Does Supervisory Discipline Reduce Bank Risk? Evidence from Before, During, and after the Crisis

Abstract

This paper investigates the effectiveness of supervisory discipline on bank risk over the years immediately before, during and just after the recent crisis. It is the first study to consider the effects of informal supervisory enforcement actions in addition to formal actions. Informal enforcement actions are not only much more numerous than the formal enforcement actions used in previous studies, but they are also often confidential, whereas formal enforcement actions must be public. Access to this information allows a complete analysis of the effects of regulatory enforcement actions on bank capital. Pre-crisis, results strongly support the risk-reducing (capital enhancing) effects of informal actions and find that using only information on formal actions leads to substantial bias. During the crisis, formal actions became a much more effective tool for slowing declines in a bank’s capital ratios and informal actions were relatively less potent. Post-crisis, while it appears that the effects of enforcement actions are moving back toward the “normal” times of the pre-crisis period, the statistical relationship between supervisory discipline and target capital is less clear. In all three periods banks had strong incentives to achieve their capital targets while they were in the higher prompt corrective action capital zones. TARP capital helped quicken a bank’s adjustment speed to its capital target during the crisis, but appears to slow this speed post-crisis.