Market Information, Bank Holding Company Risk, and Market Discipline
Timothy Curry
Gary Fissel
Gerald Hanweck*
Working Paper 2003-04
October 2003
* Timothy Curry and Gary Fissel are senior financial economists, Division of Insurance and
Research, Federal Deposit Insurance Corporation (FDIC), Washington, DC 20429. Gerald
Hanweck is a visiting scholar, Division of Insurance and Research, FDIC, Washington, DC, and
Professor of Finance, School of Management, George Mason University, Fairfax, VA 22030.
The authors thank Audrey Clement, Justin Combs, and Brian Deitch for excellent research assistance; and Andrew
Davenport, anonymous reviewers, and participants in the FDIC Research Seminar Series and in the George Mason
University School of Management Finance and Accounting Seminar Series for comments on an earlier draft. The
views expressed are those of the authors and do not necessarily reflect those of the FDIC or its staff.
Timothy Curry
Gary Fissel
Gerald Hanweck*
Working Paper 2003-04
October 2003
* Timothy Curry and Gary Fissel are senior financial economists, Division of Insurance and
Research, Federal Deposit Insurance Corporation (FDIC), Washington, DC 20429. Gerald
Hanweck is a visiting scholar, Division of Insurance and Research, FDIC, Washington, DC, and
Professor of Finance, School of Management, George Mason University, Fairfax, VA 22030.
The authors thank Audrey Clement, Justin Combs, and Brian Deitch for excellent research assistance; and Andrew
Davenport, anonymous reviewers, and participants in the FDIC Research Seminar Series and in the George Mason
University School of Management Finance and Accounting Seminar Series for comments on an earlier draft. The
views expressed are those of the authors and do not necessarily reflect those of the FDIC or its staff.
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.
2
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.
2