Bank Regulatory Certification and CAMEL Framework-related Accounting Signals in the Debt Market

This study investigates whether and to what extent bond investors in the financial institution sector free-ride on regulatory certification in non-financial crisis periods, and whether they use accounting signals in their decision-making process only during economic downturns. The recent bank crisis provides a perfect setting to test whether financial institutions’ financial accounting indicators related to the CAMEL framework of the U.S. Federal Bank Regulatory Agencies — capital adequacy, asse t quality, earnings ability, and liquidity — enter at all into the decision-making process of investors holding a portfolio of debt instruments in financial institutions. Applying a perfect foresight portfolio investment strategy (Abarbanell and Bushee, 1998), I find evidence that cumulative monthly bond returns are associated with changes in ‘earning power’ and changes in credit ratings only when financial markets are illiquid and not transparent. This is potentially attributable to diverging interests of bank regulators and institutional bond investors during bank crisis periods, with debt holders conceivably relying to a lesser extent on regulatory agencies’ private information and certification. Moreover, I provide insight in terms of bond prices that have not fully anticipated accounting signals during periods of financial distress and uncertainty. To draw causal inferences, I also conduct an event study utilizing short-term windows centered on the U.S. Securiti es and Exchange Commission (SEC) EDGAR 10-K filing announcement dates and preliminary earnings announcement dates, and report the value relevance of financial indicators related to changes in ‘earning power’, liquidity, and capital adequacy for bond holders during the recent financial crisis period.