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In Rememberance: World Trade Center (WTC)

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Incorporating Equity Market Information into Supervisory Monitoring Models

by John Krainer of Federal Reserve Bank of San Francisco, and
Jose A. Lopez of Federal Reserve Bank of San Francisco

June 6, 2002

Abstract: We examine whether equity market variables, such as stock returns and equity-based default probabilities, are useful to bank supervisors for assessing the condition of bank holding companies. Using an event study framework, we find that equity market variables anticipate supervisory ratings changes by up to four quarters and that the improvements in forecast accuracy arising from conditioning on equity market information are statistically significant. We develop an off-site monitoring model that easily combines supervisory and equity market information, and we find that the model's forecasts also anticipate supervisory ratings changes by several quarters. While the inclusion of equity market variables in the model does not improve forecast accuracy by much relative to simply using supervisory variables, we argue that equity market information should still be useful for forecasting supervisory ratings and should be incorporated into supervisory monitoring models.

Published in: Journal of Money, Credit and Banking, Vol. 36, No. 6, (December 2004), pp. 1043-1067.

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