The Impacts of Strengthening Regulatory Surveillance on Bank Behavior: A Dynamic Analysis from Incomplete to Complete Enforcement of Capital Regulation in Microprudential Policy

Abstract

This study examines the impact of strengthening bank capital supervision on bank behavior in the incomplete and complete enforcement of regulations. In a dynamic model of banks facing idiosyncratic shocks, banks accumulate regulatory capital and decrease charter value and lending in the short run, while in the long run, the banking system achieves stability. To test the short-run implications, we utilize the introduction of the prompt corrective action program in Japan as a natural experiment. Using some empirical specifications with bank- and loan-level data, we find empirical evidence consistent with the theoretical predictions.

Keywords: regulatory surveillance, incomplete enforcement, heterogeneous bank model, prompt corrective action, bank capital ratio, credit crunch

JEL Classification: G00, G21, G28.