One of the Federal Reserve System’s main tasks is to ensure the safety and soundness of the nation’s financial institutions through our supervision of their activities. At the Minneapolis Federal Reserve Bank, we support this System function in a number of ways, and one of the more important is our ongoing study and encouragement of enhanced approaches to supervision. Our Annual Report essay this year—authored by Ron Feldman and Jason Schmidt—is about one of those ideas: using financial market information as an input into the supervisory process.
The essay has two distinct pieces. The first is data-based. It documents that, in the run-up to the recent financial crisis, information in financial market data would have flagged many firms that ultimately faced collapse. Critically, in some cases, market data moved ahead of certain supervisory assessments. This evidence strongly suggests to me that the auxiliary use of market data could have encouraged supervisors to respond more quickly and forcefully to excessive risk-taking on the part of financial institutions in the period before the financial crisis.
Of course, market prices, like any other known system, are not perfect in identifying potential problematic banks. Consequently, in the second part of the essay, the authors provide a research agenda to address weaknesses in the use of market data in the supervisory process.
I’ve always been interested in the idea of using financial market information as an input into the supervision of financial institutions, and this year’s Annual Report essay has only served to increase my enthusiasm for this approach. So, I’m delighted that this idea is now being translated into specific policy proposals. Recently, the Federal Reserve Board of Governors proposed a rule that would require supervisors to take a second look at a firm when market prices indicate that the firm appears risky.* The Minneapolis Fed’s analysis over the years, and in this essay, provides strong support for the proposition that this proposed rule can help mitigate the risk of a recurrence of the events of 2008.
* See the Dec. 20, 2011, press release.