When the regulators are away, the banks will increase risk-taking behavior and have more expensive failures.
That is the conclusion of two papers studying the natural experiments that arise when regulators physically move farther away from their supervised banks. The papers were featured at the 2017 Community Banking in the 21st Century policy and research conference on Oct. 4. The conference is an annual event that highlights research looking at issues that impact community banks and culminates in an annual survey on the state of community banking.
"Does routine supervision limit risk taking at banks?" asked John Kandrac, an economist at the Federal Reserve, who looked at the impact of the 1983 relocation of the 9th district Federal Home Loan Bank from Little Rock, Ark., to Dallas, to isolate the impact of examination frequency on bank behavior. At the time, the 9th district Federal Home Loan Bank supervised savings and loans in Arkansas, Louisiana, Mississippi, New Mexico and Texas. Rather than move, most of the staff within the supervision division quit, including the chief; only two examiners moved to the new office. The loss of personnel meant that exams in the 9th district declined and did not return to levels experienced before the move until 1986.
Reduction in the number of exams had a large impact on savings and loans within the region. Institutions affected by this sudden relocation and exodus of regulatory staff took on more risk, maintained lower capital levels and experienced more expensive and a higher incidence of failures. Among these institutions, risky real estate investments as a share of assets grew by as much as five percentage points – a change that was not observed in control groups of savings and loans in other districts or commercial banks in the same district. Kandrac also controlled for the impact of energy prices on banks in this area at this time.
His results seemed to be bolstered by a paper asking a similar question with a different approach. Jens Hagendorff, a professor of finance at the University of Edinburgh, told conference attendees that he traveled across the Atlantic "to persuade [them] that supervisors affect bank outcomes, and by and large those effects are pretty positive."
His paper leveraged the setup of the U.S. federal regulatory structure and the fact that different banks in the same county can have a mix of regulatory oversight from the Federal Deposit Insurance Corp., the Federal Reserve and the Office of the Comptroller of the Currency, depending on their charters. He looked at how office closures of those regulators affected regulatory oversight of banks with less than $1 billion in assets within a specific county and compared it to other banks in the same county that were not overseen by that regulator. Although the banks would still be overseen by the regulator, the oversight would shift to a farther-away office, meaning the distance between the supervisory office and the bank would increase.
"We find increases in risk-taking and increases in the loan portfolio of these affected banks. We also show that they grow their loan portfolios more aggressively," he said.
Hagendorff chalked up some of the behavior to information asymmetry that developed between banks and the supervisors in the office that was now farther away, noting there was no change in riskiness if an office closed but a new one opened up 10 miles away or less.
He noted that this result comes at a time when supervision is becoming less local for the smallest banks, as agencies try to leverage technology to move more supervision offsite, and he cautioned the regulators in the room to balance the costs and benefits of local supervision.