The surge in bank failures in the late 1980s and early 1990s prompted many policy proposals in search of an improved regulatory and supervisory framework. One such reform urges the enhancement of market forces in the disciplining of banking institutions. This study assesses the effectiveness of one type of outside monitor, stock market participants, in identifying New England banks' exposure to the region's real estate market in the late 1980s and early 1990s. An examination of this issue is important for evaluating the potential role that private sector claimholders can exercise in the monitoring and disciplining of banks. Were shareholder reactions to the troubled real estate market consistent with individual banks' exposures to this market, or was there evidence of bank share prices deviating from their fundamentals?
The analysis relies on trading by bank managers, who are likely the best informed regarding the bank's risk exposure, to assess the market's accuracy in pricing bank stocks. By examining managerial trading around changes in the market's valuation of a bank, one can gain insight into the insiders' assessment of the market's pricing of their firms' shares. Trading activity by managers of surviving institutions suggests that the market had difficulty assessing a bank's exposure to the region's business cycle. The evidence supports the assertion that informational asymmetries are present in the banking industry. Given this environment, requiring bank managers to disclose more of their private information could improve the market's ability to discipline banks.