1Can market actors help monitor European banks?1

In order to contribute to the debate on the potential use of the signals arising from financial markets as complement to the information available to supervisors, the paper focuses on the use of timely idiosyncratic equity market information to the monitoring of large European banks. I examine this question by conducting two sets of event studies. First, I address the question of whether financial market variables can timely anticipate changes of a constructed Financial Situation Rating (FSRating) of audited banks and then whether rating agencies can add information and help monitor European banks during the period 1990-2006. The first findings suggest that cumulative average abnormal returns anticipate the “stand alone ” rating change of audited banks some quarter in advance. Thus, supervisors can derive useful monitoring information from these equity market signals but must carefully interpret excessive positive abnormal returns. The second specification, based on actions announced by rating agencies, show that positives actions are anticipated many days before the announcement date since they are associated with good information that are rapidly revealed to the market. “Watch ” announcements lead to significant price variations, with prices rising in response to positive “watch ” announcements, but not falling to negative “watch ” announcements. Stock prices react very differently to rating downgrades. Shareholders are able to anticipate downgrades but still insensible to expected downgrades. Moreover, they anticipate very late the unexpected downgrades with small negative abnormal returns. Finally, the rating agencies ’ expertise has a substantial importance since market prices react immediately after an unexpected downgrade. I conclude that rating agencies are able to collect and interpret efficiently bad news not already revealed to the public. 1 Thanks to Professor O.de Bandt for comments on an earlier draft, but all errors are mine