James T. Moser

Julapa Jagtiani

English

Research Papers in Economics

Chicago Fed Letter
ESSAYS ON ISSUES THE FEDERAL RESERVE BANK JUNE 2001
OF CHICAGO NUMBER 166
Do markets react to
regulatory information?
On November 12, 1999, banks received
permission to become full-fledged fi-
nancial service providers with the pas-
sage of the Gramm–Leach–Bliley (GLB)
Act. The GLB Act permits banks and
bank holding companies (BHCs) to
convert to a financial holding compa-
ny (FHC) structure and engage in a
broader array of new activities, includ-
ing merchant banking, as well as remov-
ing prior restrictions on their ability to
offer insurance and securities products.
To be eligible to convert to FHC status,
the firm must show both that it is via-
ble and that it is meeting the needs
of its community. The firm’s viability
is demonstrated by meeting the “well-
capitalized” and “well-managed” stan-
dards. Under the well-capitalized
standard, all bank subsidiaries con-
trolled by a converting BHC must
have a 10% total risk-based ratio, a 6%
tier 1 risk-based ratio, and a 5% tier 1
leverage ratio.1 The well-managed stan-
dard stipulates that all bank subsidiar-
ies controlled by the converting BHC
must have a rating of 1 (strongest) or
2 for their composite CAMELS ratings
and the M component (a rating of man-
agement quality). A “satisfactory” Com-
munity Reinvestment Act (CRA) rating
determines that the institution is meet-
ing the needs of the community in
which it operates.2
The CRA rating and the capital ratios
have always been publicly available. In
contrast, the composite CAMELS and
M ratings are confidential. Access to
these rating is limited to senior bank
management and the regulatory agen-
cies. However, since conversion to FHC
status is public information, the pub-
lic can infer regulatory ratings for banks
and bank holding companies when
they announce their FHC-conversion
intentions.
On March 13, 2000, the first day
applications for FHC status were ap-
proved, 117 banking firms converted.
As of the end of December 2000, 342
banking firms had converted to FHC
status. Of these, more than half (184)
were small community banks having
total assets under $500 million, and
41 were money center or superregion-
al banks each with total assets exceed-
ing $20 billion. Not surprisingly, most
of the largest 30 BHCs had converted
to FHC status as of yearend 2000.
The GLB Act created a unique oppor-
tunity for researchers to observe the
market’s reaction to confidential regula-
tory information, which had never be-
fore been available to the public. This
Chicago Fed Letter discusses findings from
a study we coauthored with L. Allen,
which examines how stock and bond
markets react to this newly released in-
formation about regulatory ratings.3
The results of our study have a bearing
on the market-discipline debate. This
debate centers on a conjecture that
market discipline may be more effec-
tive than regulatory discipline as the
U.S. banking industry has become in-
creasingly sophisticated. If so, then
market discipline might be enhanced
by making the results of bank exami-
nations available to the public.
The decision to convert
In Allen et al. (2001), we examine
characteristics that determine the de-
cision to convert to FHC status. A vari-
ety of characteristics were considered
as possible candidates, including the
regulatory requirements for conver-
sion (“well-capitalized” and “well-man-
aged”). In addition, we find that asset
size and measures of nonbank activi-
ties improve prediction accuracy.
Using these characteristics in a statis-
tical model enables us to calculate
probabilities for the likelihood of a
banking firm’s conversion decision.
Subsequently, by restricting the infor-
mation in the statistical model to only
publicly available information, we cal-
culate probabilities that proxy for those
that the market would assign for each
firm’s conversion. We use these esti-
mates to produce a two-by-two classifi-
cation of what banks were expected to
do versus what they did. Figure 1 sum-
marizes the possible combinations and
the number of BHCs included in the
four categories.
Placement in three of the four cells
effectively releases regulatory infor-
mation to the market. Converting banks
release information about their “well-
managed” ratings. The information
released can be new or may confirm
previously held opinions. For example,
unsatisfactory regulatory ratings in-
formation may have been revealed by
nonconverting banks that, based on
public information, were expected to
convert but did not convert. That is,
suppose a bank can be observed to have
acceptable capital ratios, CRA ratings,
and current financial activities, yet it
chooses not to convert. The market
might reasonably infer from this choice
that the regulatory rating proved to
be an obstacle to conversion. Lastly,
banks not expected to convert and
1. Predicted vs. actual conversion
1. Converted (Predicted to convert)
22 BHCs
2. Nonconverted (Predicted to convert)
3 BHCs
3. Nonconverted (Predicted not to convert)
295 BHCs
4. Converted (Predicted not to convert)
46 BHCs
Note: Comparison of model predictions versus actual bank
conversion rates.
Source: Allen et al. (2001).not converting release no information
about their ratings, because their de-
cision not to convert could be based
on the readily observable factors, e.g.,
CRA rating.
Evidence from the stock market
To gain an insight into how these de-
cisions might affect market opinion,
we constructed a sample of 366 BHCs.
The sample is composed of BHCs with
shares trading in the secondary market
and with financial data available. The
sample period begins 14 months before
the earliest conversion date (January
1, 1999) and runs through the three
calendar months in which conversion
activity was the greatest, ending on
June 30, 2000. As of June 30, 2000, 68
of these BHCs had converted to an FHC
structure. Of these, our probability
model assigned a high probability of
conversion for 22 firms and a low prob-
ability for the 46 remaining firms. Of
the 298 BHCs that had not converted
by the end of June 2000, our proba-
bility model gave a low probability of
conversion for 295 firms and a high
probability for three firms.
To gauge the relevance of an inferred
release of regulatory ratings, we exam-
ine their stock returns. We look at stock
returns for three subperiods: a pre-
conversion period; the conversion
period, and a post-conversion period.
Adjusting the BHC returns for market
conditions separates the unique deci-
sions of the individual BHCs from over-
all market conditions. Specifically, we
adjust the BHC returns for overall
stock market returns and returns on a
banking index. Averaging the adjusted
returns of BHCs classified according
to our probability model and their ac-
tual conversion decisions allows us to
assess the effects of the release of reg-
ulatory information. By looking at the
three different subperiods, we can mea-
sure the excess (abnormal) returns to
the shareholders of these BHCs during
the pre-conversion, conversion, and
post-conversion periods. Finally, we
also separate the change in stock re-
turns that may be a result of the change
in risk exposure (due to the BHCs’
expanded nonbank activities after the
FHC conversion) from the excess
returns due to the release of regula-
tory information.
Our results overall suggest that the
market does not use regulatory rat-
ings to assess the quality of manage-
ment of banking firms.4 The market
seems to have already incorporated
assessment of management quality
into equity prices, and the market’s
assessment does not differ from the
regulatory assessment. This does not
mean that the release of regulatory
information was irrelevant. Rather, it
appears that the market could infer
from bank examination ratings the
regulatory intent—what regulators
know and how regulators would deal
with the problems.
Regarding the risk effect, we find evi-
dence suggesting that the new expand-
ed bank powers increase the market’s
estimate of the systematic (not diversi-
fiable) risk of the banking firms. This
may be related to concerns that, as
banks expand their offerings of finan-
cial products, they may become more
closely tied to the overall economy than
when they focused on traditional lend-
ing products. Indeed, these results are
also consistent with Allen and Jagtiani’s
(2000) finding that universal banks (in-
cluding a commercial bank, a securi-
ties firm, and an insurance company)
face greater systematic market risk than
commercial banks.5 Below, we discuss
our findings for the specific groups
within the BHC sample.
1. Converted (predicted to convert)
This group comprises mostly large
banks. Because of their publicly avail-
able capital ratios, CRA ratings, and
current nonbank activities, according
to our probability model the market
appeared to “expect” these banking
organizations to take advantage of the
expanded bank powers offered under
the GLB Act and to convert to an FHC
structure.
There is no evidence of abnormal re-
turns during the conversion period for
this group. This is consistent with pre-
vious research, which finds that the
stock market returns for BHCs with
Section 20 subsidiaries (with nonbank
activities) reacted positively to the
passage of the GLB Act in November
1999. These banking firms were ex-
pected to convert and benefited from
the GLB Act as soon as it was passed.
There was no additional significant
stock market premium when these
banks actually converted.
2. Nonconverted (predicted to convert)
Banks in this group are large, active in
nonbank activities, and meet the con-
version requirements in terms of cap-
italization and CRA rating but decided
not to convert to FHC status.
There is evidence of abnormal stock
returns for this group of banks during
the conversion period. While this may
seem contradictory, we offer a possible
explanation. Consistent with Berger
and Davies (1998),6 shareholders of
these banks may take nonconversion
as good news, since they are assured
that regulators can limit the risk taking
of these banking firms.
3. Nonconverted (predicted not to convert)
Banks in this group are mostly small
and not nationally known. These small
banks were expected not to convert—
possibly because they do not satisfy the
well-capitalized criterion, do not have
satisfactory CRA ratings, and do not
currently engage in allowable nonbank
activities. The fact that they did not con-
vert, in this case, did not reveal any in-
formation on regulatory ratings to the
market. Therefore, the stock market
did not expect these banks to convert
to FHC status and reacted positively,
resulting in positive abnormal returns
for these banks. However, the result-
ing positive abnormal returns on these
banks were significantly smaller than
those observed for group 2 above.
4. Converted (predicted not to convert)
Similar to the previous group, most of
the banks in this group are also small.
These banks were not predicted to
convert since they are smaller and
had not participated in nonbanking
activities in the past. However, these
banks surprised the market by convert-
ing to FHC status, resulting in a some-
what negative reaction overall from
the stock market.7Michael H. Moskow, President; William C. Hunter,
Senior Vice President and Director of Research;  Douglas
Evanoff, Vice President, financial studies; Charles
Evans, Vice President, macroeconomic policy research;
Daniel Sullivan, Vice President, microeconomic policy
research;  William Testa, Vice President, regional
programs and Economics Editor; Helen O’D. Koshy,
Editor; Kathryn Moran, Associate Editor.
Chicago Fed Letter is published monthly by the
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ISSN 0895-0164
Evidence from the bond market
We also examine reactions from the
bond market. Unlike shareholders,
who could potentially benefit from the
upside gain from a bank’s risk taking,
bondholders are more aligned with
bank regulators in their objectives.
Thus, it is useful to observe reactions
from both stock and bond markets.
The main drawback in this part of our
analysis is that fewer banking firms is-
sue publicly traded bonds, resulting
in a much smaller sample of banks—
down from 366 BHCs in the stock mar-
ket sample to 43 BHCs in the bond
market sample. The sample includes
all the BHCs included in the stock mar-
ket analysis that had publicly traded
bonds outstanding as of June 30, 2000.
We calculated bond spreads (above
those of maturity-matched Treasury
securities) as of March 1, 2000, and
June 30, 2000. The bonds were all sub-
ordinated, straight bonds with no calls,
puts, or other options, large issues of
at least $100 million, and rated by
Moody’s and/or Standard & Poor’s.
We examined both bond spreads and
the change in bond spreads from
March 1, 2000 (just prior to the effec-
tive date of the GLB Act), to June 30,
2000 (the end of our sample period).
We investigated how the spreads of
BHCs in the four different groups were
affected by their decision to convert
to FHC structure, controlling for the
risk of these banking organizations.
The empirical evidence suggests that
the release of ratings had no significant
impact on bond spreads. In addition,
we find that spreads are smaller for
converted BHCs than for those that
did not convert. The FHC conversion,
whether expected or unexpected, gen-
erally reduced bond spreads. This in-
dicates that FHC conversion (although
it increased systematic risk exposure
to shareholders) lowered the overall
credit risk exposure to bondholders—
due to greater diversification across
banking and nonbanking activities.
Again, this is consistent with Allen and
Jagtiani (2000), who find that while
universal banks are exposed to greater
systematic risk than commercial
banks, they are more diversified and
are subject to lower volatility of returns.
Conclusion
Whether regulatory information
should be made publicly available is
being debated. Governor Laurence
Meyer describes the dilemma in the
following terms:
“Public disclosure is not going to be
easy for bankers because it may well
bring new pressures that they may
not like in the short run. … It is
[also] not going to be easy on ex-
aminers because they will have to
make some tough judgments. …”8
Our evidence contributes to this de-
bate. Our finding that the market does
not include examiner ratings in its
valuations of bank operations suggests
that instances where new information
is revealed through examiner ratings
will have little impact on stock values.
This should assuage the concerns of
bankers and lessen the likelihood of
adding to the pressures placed on
examiners.
We also find that markets value the
restraints regulators can place on bank
operations. The value of this restraint
is evidenced in the positive market
response to the nonconversion of
banks which, based on public infor-
mation, would have converted. This
result sharpens our understanding
of the value that can be added by
bank supervision activities.
—Julapa Jagtiani
Senior economist
—James T. Moser
Research officer
1These ratios are measures of the capital
levels required by the regulatory agencies.
2CAMELS is the acronym for capital, asset
quality, management, earnings, liquidi-
ty, and sensitivity to interest rate risk.
CAMELS ratings range from 1 to 5, with
1 being the highest. Banks are also re-
quired to adhere to the provisions of
the CRA. These provisions require
banks to supply financing that meets
the needs of the communities in which
they operate.
3L. Allen, J. Jagtiani, and J. Moser, 2001,
“Do markets react to regulatory informa-
tion? Evidence of indirect disclosure of
examination ratings through BHCs’ appli-
cations to convert to FHCs,” Federal Re-
serve Bank of Chicago, emerging issue
working paper series, No. S&R-2000-9R.
4We use a seemingly unrelated regression
(SUR) analysis to estimate a system of
equations.
5L. Allen and J. Jagtiani, 2000, “The risk
effects of combining banking, securities,
and insurance activities,” Journal of Economics
and Business, Vol. 52, No. 6, November/
December, pp. 485–497.
6A. Berger and S. Davies, 1998, “The infor-
mation content of bank examinations,”
Journal of Financial Services Research, Vol.
14, No. 2, pp. 117–144.
7An exception is for those banks that con-
verted immediately on March 13. For those
banks, we observe positive abnormal stock
returns during the post-conversion period,
but not during the conversion period.
8National Bureau of Economic Research,
2000, “Supervising LCBOs: Adapting to
change,” paper presented at the confer-
ence on Prudential Supervision: What
Works and What Doesn’t, Islamorada, FL,
January 14.Sources: The Chicago Fed Midwest Manufactur-
ing Index (CFMMI) is a composite index of 16
industries, based on monthly hours worked and
kilowatt hours. IP represents the Federal Reserve
Board’s Industrial Production Index for the U.S.
manufacturing sector. Autos and light trucks are
measured in annualized units, using seasonal ad-
justments developed by the Board. The purchas-
ing managers’ survey data for the Midwest are
weighted averages of the seasonally adjusted pro-
duction components from the Chicago, Detroit,
and Milwaukee Purchasing Managers’ Association
surveys, with assistance from Kingsbury Interna-
tional, LTD., Comerica, and the University of
Wisconsin–Milwaukee.
The CFMMI declined for the fifth consecutive month in February to 162.5. This
was a 1.3% decline from January’s revised level of 164.7. For the first time in five
years, February’s index level was also lower than a year earlier. The Federal Reserve
Board’s IP for manufacturing declined 0.4% in February after falling 0.6% in
January. February output in the region was 1.2% lower than a year earlier, while
output in the nation was 0.9% higher.
Auto production increased from 4.8 million units in February to 5.1 million units
in March; and light truck production increased from 5.6 million units in February
to 6.1 million units in March. The Midwest purchasing managers’ composite index
for production increased to 40.5% in April from 37.1% in March. The purchasing
managers’ index increased in Chicago and Milwaukee, but decreased in Detroit.
The national purchasing managers’ survey also increased from 42.8% to 42.9%
Manufacturing output indexes, 1992=100
1998 1999 2000 2001
125
145
165
185
Tracking Midwest manufacturing activity
CFMMI
IP
Purchasing managers’ surveys:
net % reporting production growth
April Month  ago Year ago
MW 40.5 37.1 58.6
U.S. 42.9 42.8 58.2
Motor vehicle production
(millions, seasonally adj. annual rate)
March Month  ago Year ago
Cars 5.1 4.8 5.8
Light trucks 6.1 5.6 7.1
Manufacturing output indexes
(1992=100)
Feb. Month  ago Year ago
CFMMI 162.5 164.7 164.6
IP 151.3 152.0 149.9
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Do markets react to regulatory information?

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Do markets react to regulatory information?

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Research Papers in Economics