The Value of Regulators as Monitors: Evidence from Banking

Abstract

While conventional wisdom suggests that financial supervision is costly for bank shareholders, agency theory suggests that supervisors’ audits can reduce shareholder monitoring costs. I study this trade-off in the context of an unexpected decrease in off-site surveillance by the US Federal Reserve, and I find that reduced surveillance leads to a 1% loss in bank Tobin’s q and a 7% loss in equity market-to-book. These losses come from increased internal audit expenditures and managerial misreporting, and they are larger in banks with opaque cash flows. My results document a novel substitution effect between public monitoring by regulators and private monitoring by shareholders.