Supervisory Enforcement Actions against Banks and Systemic Risk

Abstract

Prudential bank supervision is designed to enhance financial stability, but we are unaware of empirical research linking this supervision to financial system risk. In particular, there are no prior findings on how supervisory enforcement actions (EAs) – major tools of supervisors – affect systemic risk. Theory is also ambiguous, leaving important unanswered research and policy questions regarding the effectiveness of these tools. We empirically investigate relations between EAs and banks’ contributions to systemic risk. We find significantly smaller bank contributions to systemic risk after EAs than before them, suggesting that EAs enhance financial stability. The data also suggest that the primary channel behind this relation is reduced leverage, but lower portfolio risk also plays a role. We also find that the magnitude of our findings is greater during financial crises than normal times, and that EAs against banks are more effective in systemic risk reduction than those against individual bank managers.

Keywords: Enforcement actions, banks, systemic risk, leverage risk, financial crises

JEL Classification: G18, G21, G28