Abstract - Market-Based Corrective Actions: The Case of Bank Supervision

Many policy proposals suggest that bank supervision should make use of the market
prices of traded bank securities. We study the theoretical underpinnings of these proposals
in light of a key problem: if the regulator uses market prices, prices adjust to reflect this use
and potentially become less revealing. We demonstrate that these proposals are feasible only
when the information gap between the market and the regulator is not too large. Thus, there
is a strong complementarity between market information and the regulator’s information.
We demonstrate that the type of security being traded matters for the observed equilibrium
outcome and discuss other policy measures that can increase the ability of regulators to make
use of market information. Our insights are not limited to the case of market-based bank
supervision, but rather apply to a wide set of situations in financial economics, including
shareholder activism, takeovers, and the decision to replace CEOs.

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