The Penn Square Bank failure and the inefficient market

Abstract

n any observers have argued that bank z stock prices provide useful information on the financial condition of banking organizations, perhaps as good as the information provided by on-site bank examinations .or the development of early warning systems using financial ratios, and that downward changes in bank stock prices may be used as a predictor of financial distress (see Shick and Sherman [6]). On the other hand, this argument presupposes that the financial markets are adept at processing the information available on banking organizations; it then leads, as a policy prescription, to a recommendation for additional disclosure of information. While early evidence appeared to confirm the informational content of changes in bank stock prices and seemed to indicate that these prices were useful indicators of financial distress, more recent evidence has placed this hypothesis in doubt. For example, after reviewing six major bank failures, Simpson (7, p. 471 concluded, ”The ability of the capital markets to predict financial difficulties in large commercial banks before on-site examinations must be questioned.” This paper provides additional information on the transmission of information about bank securities to financial markets, by exploring the market effects of the Penn Square Bank failure that occurred in July 1982. Consistent with Simpson’s findings, the analysis suggests that the transmission mechanism is much more complex than had been thought after early studies. Important questions are also raised about the usefulness of bank stock prices in appraising the risk of banking organizations and about proposals to rely 8 more extensively on the financial markets to police the riskiness of commercial banks and other financial institutions.