In March of 2023, the U.S. banking industry experienced a period of significant turmoil involving runs on several banks and heightened concerns about contagion. While many factors contributed to these events—including poor risk management, lapses in firm governance, outsized exposures to interest rate risk, and unrecognized vulnerabilities from interconnected depositor bases, the role of bank supervisors came under particular scrutiny. Questions were raised about why supervisors did not intervene more forcefully before problems arose. In response, supervisory agencies, including the Federal Reserve and Federal Deposit Insurance Corporation, commissioned reviews that examined how supervisors’ actions might have contributed to, or mitigated, the failures. The reviews highlighted the important role that bank supervisors can play in fostering a stable banking system. In this post, we draw on our recent paper providing a critical review and summary of the empirical and theoretical literature on bank supervision to highlight what that literature tells us about the impact of supervision on supervised banks, on the banking industry and on the broader economy.  

Supervision and Regulation Are Distinct Activities 

In the economic literature on banking and in discussions of the banking industry, the terms “supervision” and “regulation” are often used interchangeably, but in fact these are distinct activities. “Regulation” is the process of establishing the rules under which banks operate: who can own banks, permissible and impermissible activities, and minimum capital and liquidity requirements. Regulations are subject to public comment and input before they are adopted, and they are published for all to see. “Supervision” involves oversight and monitoring of banks to ensure that they are operating in a safe and sound manner. A key part of supervision is ensuring that banks are in compliance with regulations, but supervision also involves qualitative assessments of banks’ internal processes, controls, governance and risk management—and taking enforcement actions when weaknesses are discovered. While some enforcement actions are public, much of supervisory activity is confidential and not publicly disclosed.

A large body of economic research has focused on the goals and impacts of regulation, but much less research has been conducted on the objectives and impacts of supervision, perhaps reflecting the limited information available on supervisory outcomes. Still, a growing body of empirical research is assessing the impact of supervision on banks and examining how supervision affects the risk-taking, lending, and profitability of supervised banks. We summarize some key findings from this work below.

Risk-taking and Performance 

It is difficult to estimate the relationship between supervision and performance because troubled banks get more supervisory attention. So, any simple analysis would probably conclude that more intensive supervision leads to problems at banks. Papers that try to estimate the impact of supervision therefore either try to compare similar banks or employ creative strategies to identify bank characteristics associated with more supervision, but not more risk. Nearly all papers examining the impact of supervision on risk-taking find that more intensive supervision results in reduced risk-taking by banks.

Delis et al. look directly at public enforcement actions, such as cease and desist orders, and find that they are associated with subsequent reductions in bank risk, suggesting that these specific types of supervisory actions are effective in causing banks to change their practices. Other papers instrument for supervision using discrete events or characteristics that result in more or less supervisory attention for particular banks, such as changes in the asset-size cutoff for certain types of supervisory reviews (see Rezende and Wu and Bissetti), distance from supervisory offices (see Hagendorff, Lim, and Armitage; Kandrac and Schlusche, Leuz and Granja), and whether a bank is among the largest in the office responsible for its supervision (Hirtle, Kovner, and Plosser). This research finds that more intensively supervised banks have less volatile income, experience fewer and less volatile loan losses, are less negatively affected by economic downturns, and/or spend more on internal controls than banks subject to less supervisory attention. 

In contrast to concerns that supervision may inhibit growth, this reduced risk does not appear to come at the expense of profitability or growth. Most papers that examine this question find that supervision has a neutral to positive effect on profitability, as reflected in equity returns, risk-adjusted returns, market-to-book ratios, or accounting net income. In a previous Liberty Street Economics blog post, we shared our result that more intensively supervised banks do not have measurably lower asset or loan growth rates than comparable banks subject to less intensive supervision. These findings suggest that supervision reduces the risk of bank failure, with little cost to bank profitability. But are there other impacts to consider in weighing the costs and benefits of supervision? 

Lending 

While more intensive supervision might not reduce bank profitability, it can have effects on other aspects of banks’ activities. The most critical of these is lending. Supervision results in less risky lending, as noted above, but does it also decrease the amount of credit available to borrowers? The papers looking at this question have found mixed results, with some finding that more intensive supervision results in reduced credit supply, while others find that risk is reduced without significantly reducing lending.

The longest-standing research on the impacts of supervision examines how the stringency of the bank examination process affects banks’ lending. In general, these papers find that increased supervisory stringency is associated with reduced loan origination or slower loan growth, though the estimated economic effects of the impact vary. Other studies have found that while supervisory actions such as guidance on commercial real estate and leveraged lending might reduce these types of loans at banks subject to the tighter supervisory expectations, the targeted banks shift into other forms of lending and at least some of the targeted lending shifts to other banks. Some studies find that lending rebounds over time as banks and borrowers adjust to the new approach.

Does Supervision Strike the Right Balance? 

In the period after the failures of several large banks in March 2023, many questions were raised about whether more forceful supervision of those banks could have prevented their failure or limited the contagion that followed. Our review does not directly address this specific event but provides some general results about the costs and benefits of supervision. One important caveat to these findings is that they were estimated at levels of supervision prevailing at the time of the analysis. It is possible (and even likely) that the free lunch suggested in the positive relationship between supervision and risk without significant impact on growth may not hold if supervision were dramatically increased from those levels.

Beverly Hirtle is a financial research advisor in Financial Intermediation Policy Research in the Federal Reserve Bank of New York’s Research and Statistics Group.  

Anna Kovner is the director of Financial Stability Policy Research in the Bank’s Research and Statistics Group.

How to cite this post:
Beverly Hirtle and Anna Kovner , “Can I Speak to Your Supervisor? The Importance of Bank Supervision,” Federal Reserve Bank of New York Liberty Street Economics, April 15, 2024, https://libertystreeteconomics.newyorkfed.org/2024/04/can-i-speak-to-your-supervisor-the-importance-of-bank-supervision/.


Disclaimer
The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author(s).

Beverly Hirtle and Anna Kovner 

Source link

You May Also Like

How Do Interest Rates (and Depositors) Impact Measures of Bank Value? – Liberty Street Economics

Stephan Luck, Matthew Plosser, and Josh Younger The rapid rise in interest…

UiPath Taps AI to Process Loan Data | Bank Automation News

Financial institutions including JPMorgan Chase, Truist Bank and Wells Fargo are using…

Bank unions defer planned bank-wise and state-wise strike action

Bank employee unions have decided to defer the planned bank-wise and state-wise…

By The Numbers: 46% of banking customers rely more on digital tools | Bank Automation News

Americans are leaning on the use of digital banking and its associated…