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 by
the US Federal Reserve, and I find that reduced surveillance 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 audit expenditures
and managerial misreporting, and they are larger in banks with opaque cash flows.
My results document a novel substitution effect between public monitoring by regulators and
private monitoring by shareholders.

Keywords: Financial Regulation, Monitoring, Shareholder Value

JEL Classification: G21, G28, G32