Inconsistent Regulators: Evidence from Banking

Abstract:     
We find that regulators can implement identical rules inconsistently due to differences in their institutional design and incentives and this behavior adversely impacts the effectiveness with which regulation is implemented. We study supervisory decisions of U.S. banking regulators and exploit a legally determined rotation policy that assigns federal and state supervisors to the same bank at exogenously fixed time intervals. Comparing federal and state regulator supervisory ratings within the same bank, we find that federal regulators are systematically tougher, downgrading supervisory ratings almost twice as frequently as state supervisors. State regulators counteract these downgrades to some degree by upgrading more frequently. Under federal regulators, banks report higher fraction of nonperforming loans, more delinquent loans, higher regulatory capital ratios, and lower returns on assets. Leniency of state regulators relative to their federal counterparts is related to costly consequences and likely proxies for delayed corrective actions—more lenient states have higher bank-failure rates, lower repayment rates of government assistance funds, and more costly bank resolutions. Moreover, relative leniency of state regulators at the bank level predicts the bank's subsequent likelihood of severe distress. The discrepancy in regulator behavior arises because of differences in how much regulators care about the local economy as well as differences in human and financial resources involved in implementing the regulation. There is no support for the corruption hypothesis, which includes “revolving doors” as a reason for leniency of state regulators. We conclude by discussing broader applicability of our findings as well as implications of our work for the design of banking regulators in the U.S. and Europe.

Number of Pages in PDF File: 59

Keywords: Banking Regulation, Banking Supervision, Dual Banking, CAMELS, Financial Institutions, European Banking

JEL Classification: G21, G28

working papers series