depending, for example, on the openness of the stock market to international flows, and on whether the equities are cross-listed on a mature exchange.

# _Empirical evidence_

The potential signaling role of equity prices is important and undervalued, even in relatively undeveloped markets. Thus for example, the “distance-to-default” measured from market prices of the equity of Thai banks predicted their difficulties in 1997 well before rating agency downgrades.<sup>8</sup> The potential of equity prices to signal risk of failure before the East Asia crisis is also well illustrated by the synthetic exercise conducted by Bongini, Laeven and Majnoni (2002) who showed the superior forecasting ability of probability of default computed from an equity-price based option price model, not only relative to published ratings but also to a synthetic measure of risk of failure based on accounting data.<sup>9</sup> Even if outside equity holders are unable to directly influence the decisions of insiders, movements in market prices do make recapitalization more costly for the insiders and represent a very transparent signal (Gropp, Vesala and Vulpes, 2002). Interestingly, evidence from Europe suggests that bank equity prices respond much more reliably to rating agency downgrades than do their bond prices (Gropp and Richards, 2001), perhaps due to a perception that the relevant banks—most of them large—are too big to fail and that bondholders are therefore unconcerned about risk. In the US, the indications are that bond and equity returns on bank holding companies usually co-move – the companies are not sufficiently near insolvency for interests of bond holders and equity holders to diverge much – except sometimes and these observations are, of course, of especial interest (Bliss and Flannery, 2001).

# **_D. Specialized information firms_**

# _The mechanism_

Auditors and rating agencies are the most relevant of the small group of specialist information firms assessing the condition of banks. Their incentives are not directly linked to the future value of the banks’ securities, but instead depend on their reputation and accreditation, which are the source of their continuing profitability. Reputation arises because, regardless of who actually _pays_ , the demand for the services of such firms depends on the degree to which they are perceived as trustworthy and reliable by the major _users_ of the information they provide: equity and bond investors respectively. Both have long been used for regulatory purposes in the US (but not in most other advanced economies) with their usefulness in this role depending on their ability to retain the confidence of the regulator. There is clearly a rental or surplus involved in this regulatory usage, which can be lost if the raters become too generous in their ratings or when auditors acquiesce in over-optimistic accounts. In the developing country context

> 8Using the KMV methodology to compute default probabilities from equity price movements it can be shown that the debt of several Thai banks were at junk-bond levels at a time in 1997 while the rating agencies were still treating them as investment-grade (Saunders, 2001).

> 9 Note however that equity-based risk measures are not correlated with bank deposit interest premiums (Opiela, 2001).

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