Joao Granja

Christian Leuz

University of Chicago

University of Chicago, NBER and ECGI

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

15/04/2020

An important question in banking is how strict supervision affects bank lending and in turn local business activity. Forcing banks to recognize losses could choke off lending and amplify local economic woes. But stricter supervision could also change how banks assess and manage loans. Estimating such effects is challenging. We exploit the extinction of the thrift regulator (OTS) – a large change in prudential supervision - to analyze economic links between strict supervision, bank lending and business activity. We first show that the OTS replacement indeed resulted in stricter supervision of former OTS banks. Next, we analyze the ensuing lending effects. We show that former OTS banks increase small business lending by roughly 10 percent. This increase is not entirely accounted by a reallocation of mortgage lending and stems primarily from well-capitalized banks and those more affected by the new regime. These findings suggest that stricter supervision operates not only through capital but can also overcome frictions in bank management, leading to more lending and a reallocation of loans.

Consistent with the latter, we find increases in business entry and exit in counties with greater expose to OTS banks.

I. INTRODUCTION

A recurring storyline 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.

 

These allegations often play an important role in justifying policy interventions that overhaul the regulatory oversight of the banking system, including tighter rules and stricter monitoring of financial institutions (e.g., Financial Institutions Reform, Recovery, and Enforcement Act 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 this paper, we use a reform of the U.S. banking system that saw a large number of banks transitioning from a more lenient to a stricter supervisor. This transition implied sweeping changes in key areas of bank management, including loan loss recognition, loan risk ratings, stress testing, and risk management, plausibly enhancing their ability to screen and manage loans, in particular, those that are information sensitive. Thus, lending could increase if stricter supervision and monitoring reduce existing agency frictions and/or adverse selection problems that prevented bank managers from lending and adopting better practices under the old regime. 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 force banks to cut lending. Our aim is to examine the economic consequences of stricter supervision, particularly, with respect to access to credit and business activity.

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