The Value of Regulators as Monitors: Evidence from Banking

Abstract

While conventional wisdom suggests that regulation is costly for shareholders, agency theory predicts a positive role for regulation in reducing shareholder monitoring costs. I study this trade-off by exploiting an unexpected decrease in small-bank supervision by the Federal Reserve, and I find that reduced Fed supervision 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 monitoring expenditures and managerial misreporting, and they are larger when bank cash flows are more volatile and opaque. My results are among the first to quantify the shareholder value of monitoring.

Keywords: Financial Regulation, Monitoring, Shareholder Value

JEL Classification: G21, G28, G32