Informational Efficiency of Markets

1. Informational Efficiency of Markets Joel Houston University of Florida September 2005

2. 3 Long-standing ideas • Long standing belief that banks specialize in collecting and processing private information. In some respects this is one of the key distinctions between private markets and public markets. • More information is generally better than less information. However, we also appreciate the fact that private information is a double-edged sword – sometimes it can be used to resolve problems and create problems. In other instances, it creates problems and reduces value. • General belief that public information gets rapidly and efficiently incorporated into market prices and that market prices are therefore informative.

3. 3 Issues Addressed in These Papers • To what extent is information from private loan markets transferred to public markets? • Under what conditions does it make sense for regulators to use market prices as part of the regulatory process? • When closing a financial institution does it make sense to transfer the assets to an informed party who has private information about their value, or do the resulting conflicts of interest make this a bad idea?

4. Overall Assessment • The Allen and Gottesman paper highlights the informational efficiency of markets. Provides evidence that information is efficiently transferred from loan markets to public stock markets. The other two papers emphasize situation where information is not efficiently transferred. • Each is well done. I don’t have any major critiques. Just some somewhat random thoughts and some questions about what to make of all of this.

5. “The Informational Efficiency of the Equity Market as Compared to the Syndicated Bank Loan Market” • Basic idea: Examine the links between the secondary market for syndicated loans and the equity market. • Interesting database. I learned a lot about the details of this market. Urge everyone with an interest in this topic to take a look at it. • The study looks at firms with outstanding syndicated debt that trades in secondary market and outstanding equity. Asks when there is new information about the firm does it show up first in the loan market or the stock market?

6. 4 Hypotheses • Private information hypothesis – loan market leads equity market. • Liquidity hypothesis – equity market leads loan market. • Asymmetric price reaction hypothesis – loan returns respond more to bad news, equity markets respond symmetrically. • Integrated markets hypothesis – information flows freely between the two markets.

7. General Thoughts • Conclusions make sense – perhaps the results are not all that surprising. • Tricky data issues. • Weekly data? Advantages/Disadvantages? • Are prices in the loan market accurate? • Notable that the focus is on “normal” time periods – i.e. this is not event driven. Advantages/Disadvantages? Are you throwing out noise or de-emphasizing what’s important?

8. Some More Thoughts • Not sure that you have completely ruled out the private information and liquidity hypotheses. • Authors state that they would expect the link between the loan market and equity market to be stronger in those cases where you would expect private information to be more prevalent/more important. Valiant effort here – but I am still not sure … • Lack of support for private information hypothesis – what does it mean? • These syndicated loans are not all that special or information intensive – effectively these are public securities. • Equity market does believe that the loan market is informative, but price changes are equally informative. • Liquidity hypothesis – can you test with weekly data?

9. In a nutshell … • Data is neat. Tests are well done. In many respects I think they have done the best they can. I question, however, the reliability of some of these prices and the use of weekly data. • Need to do more to emphasize the implications. Useful for traders – what does it mean for investors? What does it mean for regulators? etc.

10. “Banking Relationships and Conflicts of Interest …” • Looks at an interesting angle of an interesting case -- the Korean banking reform in 1998. • Loans to failing banks transferred to healthier banks. In some cases the healthier banks had a pre-existing relationship with the borrower, in other cases they did not. • 2 key questions: • What happens to the value of the borrowing firms in both the short run and in the long run? • Do the results depend on whether the borrower had a existing relationship with the bank?

11. The Effect on Borrower Returns • During the 3-day window around the time of closure – CAR is -4.85%. Similar to Slovin, Sushka and Poloncheck result for firms that borrowed from Continental Illinois. The CAR from -7 to +5 is even more negative (about a 20 percent hit). • In the long run, however, things turn up. CAR from +6 to +51 is +22.39%. The overall period from -1 to +51 is positive but not statistically significant. • Interesting – perhaps it suggests that policymakers shouldn’t worry about transferring loans from troubled banks to healthy banks.

12. The Impact of Existing Relationships • The more surprising finding is that the abnormal returns of borrowers who had no prior relationship with acquiring banks are significantly higher than the returns for the borrowers who had a prior relationship. • Striking conclusion – “It is critical that the close connection between bank management staffs and client firms be completely severed in a bank restructuring, without which the problem of bad debt cannot be completely resolved.”

13. Explanation offered: Prior lender has a conflict of interest • Basic idea: Banks with prior relationship may inappropriately grant a renewal because it strengthens the position of its existing loan. The market presumably understands this conflict and therefore responds less positively to the announced renewal. • Author sketches a model – suggests that this effect is more likely to occur when the borrower has large loan balances with prior banks and when the cost of screening is relatively low.

14. General Thoughts • Pretty interesting. • How robust is this result? Author conducts a range of robustness tests. Still wonder if there isn’t something else going on. I suspect that the result may be quite sensitive to the window in which the CAR is estimated. Arguably the most appropriate window is the longest window which takes into account the entire event. Not sure that there is a significant difference when you look over the entire time period. • I am not sure I fully understand the intuition behind the conflict of interest argument. • Firm value vs. Equity value?

15. “Using Price Information as an Instrument of Market Discipline in Regulating Bank Risk” • As the authors point out there has been a move towards greater reliance on market discipline. • To better understand the links between optimal regulation and market prices, they derive the conditions it makes sense for regulators to use market-based regulation. • This is a timely issue and an important exercise.

16. Initial thoughts (biases) • Markets do (usually) provide useful information. • More information is better than less. • Consequently, I am not all that surprised to find that evidence that markets price risk, and I tend to agree with those that believe that market discipline should be an important component of effective bank supervision.

17. At the same time ….. • A reasonable person could conclude that markets don’t give bank regulators a lot of information that they don’t already have. • A reasonable person could argue that bank managers (and supervisors?) are unable/unwilling to meaningfully take into account at least modest changes in market prices. • This could leave a reasonable person to conclude that market discipline may not be the panacea that many suggest it is.

18. Interpreting evidence is tricky • Just because there is a market response, it doesn’t necessarily mean that market discipline is very meaningful or cost-effective. • Just because we don’t see large market responses to changes in bank condition doesn’t necessarily mean that market discipline is irrelevant.

19. Thinking more clearly about market discipline • In a vague way, many of us talk about the importance of market discipline, but I am not sure how all of this translates in practice. • What market information do you use? • When do you use it? • What do you use it for? • Because the empirical evidence is often hard to interpret, I think this is an area it makes some sense to go back to basics and look at this issue from a more theoretical perspective.

20. An Overview of the Model • Interesting model that is well done. • Regulator decides whether to audit a bank, and if so whether to close the bank. • Regulator has access to: • The bank’s stock price. Based on this information it can decide whether it makes sense to audit. • At a cost it can observe the bank’s asset choice (safe or risky assets). • At a cost it can observe a signal regarding the bank’s expected return. • Given the price, the observed choice of assets and the signal, the regulator decides whether it makes sense to close the bank.

21. The Model (con’t) • At the same time there is also an outside investor who independently collects information about the bank’s prospects. Their signal has same precision as regulator’s signal, but the two signals are not perfectly correlated. • In this environment, the regulator’s use of market prices has two important effects: • It affects the investor’s willingness to acquire information. • It affects the bank’s optimal portfolio (i.e. it affects bank risk).

22. Basic Result • Value of market prices depends on the magnitude of the asset substitution problem. • When risk shifting incentives are low, things work well. • However, when risk shifting incentives are high, regulators are better off in the benchmark case (where they ignore market prices). • Suggests that market discipline lets us down when we need it most …?

23. What do we take from this? • Again the model is well executed – the question is what can we take from it? • Leaves some unanswered questions. • How do we know when risk shifting incentives are large or small? • What happens when the magnitude of these incentives evolve over time? (Do potential problems make it so we should never use market prices?) • Are there other tools in the toolkit which can make market discipline more universally valuable? • Bottom line – I think this is an interesting start.

24. Concluding thoughts • These are three interesting papers – each contributes in an important way to our understanding of the informational efficiency of markets. • In many ways they lead us to question “conventional wisdom” and stress once again that there are often unattended consequences related to private information, and that the links between public and private information are not always straightforward.