Stricter banking supervision boosted lending

Alex Verkhivker | Mar 21, 2018

Sections Accounting

After banking crises, there’s an inevitable call for stricter rules and oversight, as the public blames regulators for not having cracked down on weak banks. This was true after Washington Mutual, IndyMac, and Countrywide Financial failed in 2008, and the ensuing financial meltdown led to a regulatory overhaul that included the Dodd-Frank Act.

But regulation involves trade-offs, and does stricter banking supervision end up hurting the economy? Chicago Booth’s João Granja and Christian Leuz consider the effects of one recent banking reform and conclude that it actually had positive effects, including at banks that were already pretty strong.

The researchers home in on the US’s Office of Thrift Supervision, which prior to the 2007–10 financial crisis oversaw many savings banks and savings-and-loan institutions. Created in the wake of the savings-and-loans crisis of the 1980s, the OTS was blamed for lax oversight and dissolved in 2011, as prescribed by the Dodd-Frank Act. Roughly 10 percent of the country’s depository institutions were sent to other regulators, which allowed the researchers to analyze how the ensuing stricter oversight affected banks and their lending. 

The change forced many banks to look more closely at their lending policies and risk management. And despite the fragile recovery, this proved good for entrepreneurs: former OTS banks increased their new small-business lending by 10 percent. Affected banks increased small-business lending more than nearby banks whose oversight hadn’t changed, and that led to more new businesses. The pattern was less rosy for existing establishments, however, and more of those closed up shop in areas where former OTS banks had a greater presence.

The evidence finds that poorly capitalized former OTS banks reduced lending, on average, suggesting that the new regulatory standards forced these institutions to halt lending. But the lending effects varied with the strength of the bank. With stricter supervision, stronger banks lent more to small businesses, while weaker ones didn’t.

The positive effects were stronger for banks that were more likely to have received greater attention from the new regulators, which the researchers measured in part by looking at each bank’s physical proximity to the new regulator. Former OTS banks that found themselves closer to their supervisor’s field office saw more lending—as did former OTS banks with bigger changes in loan provisioning, as those changes were likely induced by their new overseers.

Why didn’t strong banks improve their practices and lending earlier? It could be that stricter supervision forced them to overcome existing “agency frictions,” the research suggests. Banks may have been reluctant to recognize bad loans for a number of reasons—from friendships with locals to reputation concerns, or simply because bankers were comfortable with their practices and not eager to change them. Ultimately, stricter regulation forced banks to improve practices and lend more to entrepreneurs, which boosted local economies.

“Stricter supervision can increase bank lending even for well-capitalized banks, suggesting that its economic effects go beyond the capital channel,” write Granja and Leuz.