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 intensity by the U.S. Federal Reserve. Banks subject to reduced surveillance experience a 1% loss in bank Tobin’s q and a 7% loss in equity market-to-book. These banks engage in more earnings management, and appear to compensate lower regulatory surveillance with costly internal audits. My results document a novel substitution effect between public monitoring by regulators and private monitoring by shareholders. This paper was accepted by Victoria Ivashina, finance. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2021.03083 .