Banking regulators operate differently under public scrutiny

Martin Daks | Oct 01, 2020

Following a wave of savings-and-loan failures in the 1980s, US lawmakers enacted a suite of regulatory changes as part of the 1989 Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA). Among other things, the new law required that regulators make their enforcement decision and order (EDO) documents against banks and other financial institutions public—a move toward transparency that has broadly changed the behavior of bank monitors as well as outcomes for banks, find the Federal Reserve Board’s Anya Kleymenova and Chicago Booth’s Rimmy E. Tomy.

Comparing regulators’ behavior before FIRREA (when EDOs were generally not made public) with their behavior after the disclosure mandate, Kleymenova and Tomy find that regulators tend to take action more often, and earlier, now that their decisions are subject to public scrutiny. The researchers argue that reputational concerns are likely drivers of these changes, and that the impact on the banking community has been mixed.

To identify pre-FIRREA enforcement actions, Kleymenova and Tomy relied on publicly available termination documents, and hand-collected a subset of 1983 and 1984 predisclosure enforcement actions from the US National Archives. They then compared these with post-FIRREA EDOs issued between 1989 and 1997, which are a matter of public record, and find that regulator interventions changed in some striking ways since the shift in disclosure regimes.

Along with more enforcement actions taken—for example, a bank in the 75th percentile of nonperforming assets was 1.48 times more likely than a bank in the 25th percentile to receive an EDO before FIRREA, but 1.75 times more likely after it—EDO documents themselves became longer and more complex. The average number of words increased by 46 percent, and the postdisclosure documents displayed lower clarity and higher numerical intensity and required an additional 5.5 years of education to comprehend. Further, Kleymenova and Tomy observe an increased use of boilerplate language in EDO documents after the regime change, which suggests the reports are not necessarily more informative.

They argue that these changes to the content of EDO documents indicate a concern among banking regulators for their own reputations, a notion that is corroborated by comparison of EDO issuance in counties with higher and lower news circulation before and after FIRREA. Relative to the predisclosure regime, regulators were 40 percent more likely post FIRREA to issue enforcement actions in locations with higher news circulation—the researchers define circulation using the number of newspapers relative to the county population in a given year—and they intervened 31 percent faster. 

Enforcement disclosure, and regulators’ reactions to it, has had meaningful implications for affected financial institutions, argue Kleymenova and Tomy. They observe that banks served with an EDO during the post-FIRREA period they studied were 36–45 percent more likely to fail, compared with the prediclosure regime, as public disclosure drove depositors to withdraw their funds. Despite improving their capital ratios by 1 percent relative to banks without an EDO, banks receiving an EDO in the disclosure regime failed 74 percent faster, or nearly nine months earlier, than banks that received an EDO in the nondisclosure regime.