How might financial market information Be used for supervisory purposes? by J. Krainer & J.A.Lopez, Federal Reserve Bank of San Francisco Economic Review 2003: a review.

Abstract

Banking services are extremely important, especially in a free market economy. However, in spite of banks catalytic role in the transmission mechanism of monetary policy, they are exposed to a lot of risks, such as liquidity, operational, market and credit risks, among others. To guard against such risks, most economies have created public safety nets as well as banking supervisory agencies and institutions of various forms to protect both the depositors and other banks/shareholders from systemic shocks that could destabilize the system. In the conduct of its supervisory functions, most central banks adopt an on-site and/or an off-site monitoring system, utilizing information such as assets quality and earnings, deposit liabilities, bank rating models, and contingency frameworks to assess the soundness and stability of the banking system. However, it has become increasingly evident that a bank's condition could deteriorate rapidly and where examination is rather infrequent, the banking supervision assessments could become outdated. This informed the work of Krainer and Lopez in considering the use of financial market information for supervisory purposes. The paper, therefore, attempts to ascertain (adopting univariate event studies and multivariate analysis), whether financial market claims, such as equity, bonds, debts, uninsured deposits, etc, accurately assesses banks conditions and how such information might be used for supervisory purposes. Broad conclusions therefrom were that implicit in the investment decisions of most financial investors were performance evaluation of the financial institutions. However, additional information as reflected in the financial market prices profers new and complementary approaches to supervisory functions of monetary authorities.