The Committee on Capital Markets is engaged in a study on the role of market discipline in determining and maintaining adequate capital levels for financial institutions. As described in the Committee’s May 2009 Report, the financial crisis has underscored the importance of banks maintaining adequate levels of capital.  We have concluded that the Basel process of determining capital requirements by regulation has not been entirely successful in achieving this objective. This study considers the manner in which market discipline can augment both government and market approaches to enforcing capital requirements.

In the first stage of this study, several academics produced papers for the Committee, focusing on five topics:

Optimal design of periodic, government-imposed stress tests

  • Prepared by Til Schuermann, Partner, Oliver Wyman

The impact of public disclosure of stress test results

  • Prepared by Itay Goldstein, Associate Professor of Finance, Wharton School, University of Pennsylvania, and Haresh Sapra, Professor of Accounting, The University of Chicago Booth School of Business

Appropriate measures of capital

  • Prepared by Mark J. Flannery, Bank of America Eminent Scholar, Chair of Finance, University of Florida, Warrington College of Business Administration

Market mechanisms that could be used to control bank capital, e.g., contingent capital

  • Prepared by Arturo Estrella, Professor of Economics, Chair of Economics Department, Rensselaer Polytechnic Institute

The need for additional disclosures from banks and financial institutions

  • Prepared by John Lester, Partner, Oliver Wyman

The second stage of the study, which we expect to publish in 2013, will expand on the papers prepared during the first stage and will include specific policy recommendations. Further research will include an examination of the ways that regulation can improve the quality and credibility of market signals about banks’ capitalization. Two channels for the flow of information will be considered:

  • Information from the market – i.e., identifying the market information that gives regulators the most credible signal of a bank’s capital strength
  • Information to the market – i.e., how regulations can enhance the information that the market uses to assess banks

To supplement this research and to serve as an intellectual resource for these experts, the Committee established an Advisory Committee, co-chaired by Professor Luigi Zingales and Hal S. Scott, whose members are Professor Douglas Diamond of The University of Chicago Booth School of Business and Professors Kenneth A. Froot and David S. Scharfstein of Harvard Business School.