Banking Stability, Reputational Rents, and the Stock Market: Should Bank Regulators Care About Stock Prices?

50 Pages Posted: 21 Dec 2001

See all articles by Anjan V. Thakor

Anjan V. Thakor

Washington University, Saint Louis - John M. Olin School of Business; European Corporate Governance Institute (ECGI)

Date Written: December 2001

Abstract

In this paper I begin with a model that generates quantity credit rationing by banks in the spot credit market when the stock market is not doing well. Then I provide a theoretical rationale for a bank loan commitment as partial insurance against such future rationing. Incorporating uncertainty about both the creditworthiness of borrowers and the abilities of banks to screen borrowers, I show that the reputational concerns of banks can lead to an equilibrium in which loan commitments serve their role in increasing the supply of credit relative to the spot credit market, but produce the inefficiency of excessive credit supply when the stock market is doing well. Despite this, welfare is higher with loan commitments than with spot credit. I use this result to then examine whether the level of the stock market should matter to bank regulators. My analysis suggests that it should, but not for the usual reason that a bull stock market could trigger inflation. Rather, it is because reputation-concerned banks lend too much during bull markets, leading to a worsening of credit quality and a higher liability for the federal deposit insurer. More stringent stock market information disclosure rules tend to attenuate this distortion and thus deserve consideration by bank regulators. A regulatory policy implication of the analysis is that regulation should be "state-contingent" - regulatory auditing of bank asset portfolios should be more stringent during bull stock markets.

Suggested Citation

Thakor, Anjan V., Banking Stability, Reputational Rents, and the Stock Market: Should Bank Regulators Care About Stock Prices? (December 2001). AFA 2002 Atlanta Meetings. Available at SSRN: https://ssrn.com/abstract=294774 or http://dx.doi.org/10.2139/ssrn.294774

Anjan V. Thakor (Contact Author)

Washington University, Saint Louis - John M. Olin School of Business ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

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