The information content of bank examinations

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Abstract
The role of information acquisition for bank regulators is important for the recognition and possible control of bank risk. This role is also consistent with the modern theory of banking under which banks hold a substantial amount of private information about their loan customers, and by implication, private information about their own conditions. The authors suggest that the main purpose of bank examinations is information acquisition. In order to maintain the safety and soundness of the banking system, regulators conduct regular on-site reviews of operations and determine a composite rating for the institution, known as its CAMEL rating. The authors test whether bank exams do in fact result in significant information acquisition. Their tests involve observation of how capital markets react around the times of examinations and whether these reactions are related to changes in examination ratings. They use event study methodology and track the cumulative abnormal returns on an institution's stock price before and after the examination relative to the predictions of a two-factor market model. Data are for institutions whose stocks were actively traded on major exchanges from 1985-1989 - a relatively stable regulatory regime. The question of whether bank examinations succeed in discovering substantial private information about loan quality and bank risk is crucial to answering policy questions regarding financial system reform. The modern theory of banking often rests on the assumption that are delegated monitors because of scale economies in information acquisition about borrowers. An extension of this theory might suggest that there are economies of scale in "monitoring the monitors". These economies of scale do not necessarily imply that government agencies should be the monitors. However, under the current federal safety net and deposit insurance regime, the federal government bears greater losses than do their creditors in the event of bank failure. One
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