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 US 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.

Keywords: Financial Supervision, Off-Site Surveillance, Shareholder Value

JEL Classification: G21, G28, G32