The Death of a Regulator: Strict Supervision, Bank Lending and Business Activity

A recurring theme in banking crises is the public backlash against bank supervisors for their failure to take prompt and decisive action to unearth and correct problems of weak banks. The latest crisis is no exception. A recent poll by the Initiative on Global Markets (IGM) at the Booth School of Business shows that leading economists view ‘flawed financial sector regulation and supervision’ as the most important factor contributing to the 2008 Global Financial Crisis. Perceived regulatory failures in the past often play an important role in justifying interventions that overhaul the regulatory oversight of the banking system, including tighter rules and stricter monitoring of financial institutions (eg, Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989; Dodd-Frank Act of 2010). Despite the importance of such interventions, we have limited evidence on the economic trade-offs associated with reforms that aim to limit regulatory forbearance and promote stricter bank supervision.

In a recent paper, we examine a reform of the US banking system that eliminated the Office of Thrift Supervision (OTS) that saw a large number of banks transitioning from the OTS to other regulators, ie, the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC). This regulatory change affected roughly 10% of all depository institutions. It was stipulated by the Dodd-Frank Act and was based in part on a perception that lax prudential supervision played a significant role in the failures of Washington Mutual, IndyMac, and Countrywide. The regulatory transition implied a major change in supervision and lead to sweeping changes in key areas of bank management, including loan loss recognition, loan risk ratings, stress testing, and risk management. Consistent with greater regulatory scrutiny after the transition, we find that loan loss provisions, charge-offs, and nonperforming loan ratios of former OTS banks exhibit a sharp increase following the OTS replacement, relative to other banks that were not subject to changes in banking supervision.

As the regulatory transition prompts banks to revisit their lending policies and risk management, ie, how banks assess and manage their loan portfolios, bank lending could increase. Alternatively, a stricter regulatory stance by the new supervisor could put pressure on the balance sheets of transitioning banks, especially when the recovery is still fragile, and in turn could force banks to cut lending. Our goal was to shed light on these links and to examine the economic consequences of stricter supervision, particularly with respect to access to credit and business activity.

We show that former OTS banks increase the total amount of small business loans originations by roughly 10% relative to the period prior to the OTS elimination. We obtain this result after comparing changes in lending of former OTS banks with changes in lending by other commercial banks operating in the same county and in the same year. Thus, the lending effect is not driven by former OTS banks being located in counties with better economic conditions (loan demand) but rather by an increase in the origination of small business loans by former OTS banks relative to other banks operating in the same county and in the same year (loan supply). We also find that the increase in credit supply is associated with an increase in business dynamism in counties with larger exposures to former OTS banks. The entry rate of new businesses increases relatively more in counties with greater exposure to former OTS banks. However, consistent with the notion that stricter supervision makes it harder to evergreen loans to existing establishments, the exit rate of establishments also increases in these counties. Thus, findings suggest that former OTS banks reallocate their lending from old to new establishments.

One potential reason for not seeing a decline in lending as supervision tightens is that former OTS banks were, on average, sufficiently well-capitalized so that they could absorb the additional losses the new supervisors forced to them to recognize without having to recapitalize. Consistent with this reasoning, we find that the positive effect of stricter supervision is concentrated in former OTS banks with above-average capitalization ratios prior to OTS extinction. Thrifts with below-average capital ratios exhibit a decline in their small business lending, consistent with the more traditional capital channel.

But why did well-capitalized banks wait until the regulatory transition forced thrifts to revisit their lending practices, rating systems and risk management? A likely explanation is that stricter supervision prompts banks to revisit their systems and practices and in doing so overcomes existing agency frictions, be it a reluctance to recognize bad loans because of career concerns, cozy local relations that generate private benefits and exert pressures to evergreen bad loans, or simply a preference for a ‘quiet life.’ Such frictions would explain why bank managers were reluctant to recognize loan losses and overhaul their lending practices, rating systems and risk management on their own. Consistent with this explanation and frictions in bank management, we document stronger lending effects for banks that are more strongly  affected by the new regime. That is, we find more lending (i) for former OTS banks with larger changes in loan provisioning and loss recognition after the regulatory transition and (ii) for thrifts that likely received greater regulatory attention because their headquarters are located more closely to their new supervisor’s field office and (iii) for thrifts that experience significant board turnover following the OTS extinction.

In sum, our findings suggest that strict supervision can improve banks’ credit supply, especially for well capitalized banks. It can overcome existing frictions in bank management and lead to changes in how banks assess and manage their loans. These changes in turn improve banks’ supply and allocation of credit. This novel result is likely particularly relevant for banking systems with a significant fraction of smaller and perhaps less sophisticated banks.

The complete paper is available for download here.

Joao Granja is Assistant Professor of Accounting at the University of Chicago Booth School of Business.

Christian Leuz is the Joseph Sondheimer Professor of International Economics, Finance and Accounting at the University of Chicago Booth School of Business.