Market Information, Bank Holding Company Risk, and Market Discipline

Abstract

This paper assesses the timing and magnitude of equity market valuations of bank holding companies (BHCs) in relation to changes in their risk assessments, as proxied by changes in supervisory ratings for these organizations. In particular, equity market indicators such as market-to- book value, abnormal returns, return volatility, market valuation, price covariance, and trading volume are used to determine if they can provide timely market signals as well as add incremental value to models predicting changes in supervisor-assigned BOPEC ratings of bank holding company risk. To analyze this issue, we took 3,974 bank holding company inspections from a sample of bank holding companies whose stock was publicly traded on major exchanges over the 1988-2000 period. We specify two statistical models: (1) an ordered logistic model, which is used to test the ability of lagged financial market variables, lagged financial accounting data, and past supervisory assessments to predict BOPEC rating changes; and (2) an OLS model, which is used to test the relationship of lagged BOPEC rating changes and lagged financial accounting ratios to predict financial market variables. These models taken jointly are used to test the hypotheses that (1) equity market information adds to the ability to forecast changes in banking company risk, as measured by changes in BOPEC ratings, and (2) supervisory risk ratings have the ability to lead stock market valuations of banking companies' performance. The analysis is conducted for three distinct economic and banking periods: recession and banking crisis (1988-1992), economic recovery (1993-1995), and economic expansion (1996-2000). The findings for the first model show that financial markets can add forecast value to financial accounting data and supervisory factors in predicting future BOPEC ratings. The results reveal a relationship between market indicators and supervisory rating changes of BHCs, reflecting risk conditions that flow from market valuations to supervisory rating changes. The findings for the first model were statistically significant for all three of the periods studied. Out-of-sample forecasts show that market information sometimes improves the ability of the models to forecast upgrades, downgrades and no-rating changes. This suggests that a multiple-model approach may be superior to one using a single model to forecast BHC risk assessments. The findings for the second model reveal that regressing financial market variables on lagged BOPEC changes and lagged financial accounting information is only moderately suggestive of a relationship between lagged supervisory rating changes and equity market variables. In summary, the findings provide empirical support for the presence of market discipline to the extent that the hypothesized market variables add incremental value to the model in predicting changes in bank holding company risk ratings. To this extent, the financial markets appear to be providing some degree of independent oversight to BHC management, besides the oversight provided by bank supervisors and holding company directors.