Do Markets React to Bank Examination Ratings? Evidence of Indirect Disclosure of Management Quality Through BHCs' Applications to Convert to FHCs

Abstract

Certain nonrecurring circumstances associated with the passage of the Financial Services Modernization Act of 1999 have created a unique opportunity for the market to obtain bank examination ratings of management quality. We utilize this natural experiment in order to determine how the market views this heretofore private information. We find that the stock market utilizes bank examination ratings in order to reveal regulatory intent, rather than simply as information about management quality. Revelation of unsatisfactory M ratings (denoted “bad news”) causes BHC stock returns and market risk betas to increase, whereas revelation of acceptable M ratings (“good news”) causes BHC stock returns and market risk betas to decrease. The market thrives on “bad news” because unsatisfactory M ratings indicate that regulatory intervention is likely to occur, possibly benefiting both shareholders and creditors. On the other hand, revelation of acceptable M ratings (“good news”) indicates that bank regulators are unprepared to intervene in the near future. Moreover, we find lower bond spreads for a subsample of FHCs with satisfactory M ratings revealed upon conversion.