Cost and benefit of regulatory oversight
Evidence from US commercial banking

JuliusKielaitis / Shutterstock.com

Subscribe to
The Ledger
Get AEI's weekly snapshot of economic news, views, and cues.

First Name:
Last Name:
Email:
Zip Code:

Abstract

Can access to regulators provide operational benefits to firms? Using evidence from commercial bank performance between 2001 and 2010, we show that it does: banks closer to examination field offices are able to lower their costs of operation. We interpret our findings as support for the idea that proximity to regulators facilitates informal contact which can be the basis of cost-reducing information exchanges and knowledge transfers. Alternative explanations, such as the capture of rents created by colluding firms and regulators, or more risk-taking by banks that maintain closer relationships with their supervisors, cannot account for our empirical findings.

Introduction

In this paper we study the impact of regulatory oversight on the cost of doing business for firms in the US commercial banking industry. While the social benefits of regulation have been widely studied and there is an extensive literature estimating the average, marginal, and social costs of regulatory oversight within a given industry (see e.g. Gerwig, 1962; Ipollito and Mason, 1978; Sloan, 1981; Gollop and Robert, 1985; Heckman and Pag´es, 2000; Quigley and Raphael, 2005; Anderson and Sallee, 2011; Cicala, 2013), there has been very little work exploring how compliance costs vary across firms within a particular industry. Nonetheless, the frictions inherent to enforcement relationships have the potential to introduce firm performance heterogeneity. This paper seeks to study whether such variation in performance outcomes exists.

Specifically, we investigate how banks' ease of access to their regulators are related to administrative compliance costs for banks. In the US, all but the largest banks are monitored by teams of traveling examiners who periodically assess the "safety and soundness" of portfolio choices, control systems, and management. These exam teams have substantial power and discretion over the implementation of regulatory guidance, and exam results are highly confidential, making regulatory relationships a potentially important source of variation in the cost of complying with regulation across firms. Closer regulatory relationships, characterized by more frequent informal contact, may lower the cost of compliance and facilitate the exchange of best practices. In this way, proximity can serve as an important resource to complement a firms' own internal systems of control. Alternatively, lower access costs could lead to wasteful rent-seeking or influence-buying, decreasing firms' efficiency and promoting uneven implementation of oversight.

This paper draws on evidence from regulatory supervision in the US commercial banking industry to test how firm performance and compliance levels vary with barriers to regulatory relationships, as measured by physical distance. To the best of our knowledge this is the first paper to provide a quantitative estimate of this impact.

In order to address our research question empirically, we need a proxy for regulatory access that is not endogenous to financial performance. For example, a na¨ıve measure might be the number of phone calls or visits between firms and regulators, but these are likely to be driven by a firm's financial condition. Instead, drawing on the economic geography literature (Coval et al, 2001; Malloy, 2005; Degryse and Ongena, 2005; Kedia and Rajgopal, 2011), we proxy for variation in the cost of regulatory access by measuring the driving time between each bank and their main regulatory field office. We exploit the fact that the jurisdictions of different regulatory agencies overlap to compare the performance of similar banks which operate at the same location but are at different distances from their regulators. This allows us to estimate the differential effect on cost that distance to one's own regulator has while controlling for location.

Using this proxy for the cost of regulatory access, we find that proximity is beneficial to the firms under study: banks located at a smaller distance from their supervisor face lower administrative costs, at a rate of about 0.5 to 1 percentage points of risk-based capital per hour of travel time. One explanation for this finding is that these lower costs reflect preferential treatment of closer banks, but we present evidence that this is not the case. First, there is no evidence that compliance levels, as measured by non-performing loans or firm leverage, vary across supervisors' jurisdictions, implying no difference in enforcement itself within supervisory jurisdictions. Second, lucrative relationships to form between large firms and their regulators, while small firms suffer in comparison (Stigler, 1971; Peltzman, 1973). However, we find that the benefits of supervisory proximity accrue to both small and large banks. These results lead us to believe that close ties between firms and regulators create actual value in the sense that learning, monitoring and the exchange of best practices are facilitated by them, as suggested by Petersen and Rajan (1994) in the context of market interactions.

To the extent that proximity proxies for closer relationships with regulators, this research has important implications for managers. If regulators impose an administrative burden when access costs are lower, managers should adopt an arms-length approach to oversight relationships; if regulators provides resources, information or learning opportunities, as we find, a more collaborative stance is in managers' interest. Our results also have implications for the literature that seeks to characterize the value of firms' government relationships. The literature on political connections tends to emphasize the rent-capturing potential of relationships with government agents (Fisman, 2001), particularly those with the stable tenure that characterizes bureaucracies. While the value of regulatory relationships is certainly linked to the institutional context, such as the strength of regulators' enforcement mechanisms and public accountability, this study provides novel evidence that a firm's positioning with respect to regulatory agencies has the potential to create operational value.

This has implications for public policy that are strikingly different from those derived from the rentseeking literature: the expertise and knowledge provided by regulators are a valuable public good, even though the uneven access firms have to them partially offsets its benign impact. It suggests that regulatory capacity creates positive spillovers that go beyond the mere provision of stability and soundness to the banking sector, but it also shows that these interventions tilt the playing field.

Download the PDF to read the full paper.

Also Visit
AEIdeas Blog The American Magazine
About the Author

 

Stan
Veuger

What's new on AEI

Defeating ISIS: AEI experts weigh-in before the president’s address on Wednesday
image Degrading, defeating, and destroying the Islamic State
image Wealth Building Home Loan: Building wealth through homeownership and retirement savings
image The $3 iPhone
AEI on Facebook
Events Calendar
  • 15
    MON
  • 16
    TUE
  • 17
    WED
  • 18
    THU
  • 19
    FRI
Tuesday, September 16, 2014 | 5:00 p.m. – 6:00 p.m.
The Constitution as political theory

Please join us for the third-annual Walter Berns Constitution Day Lecture as James Ceasar, Harry F. Byrd Professor of Politics at the University of Virginia, explores some of the Constitution’s most significant contributions to political theory, focusing on themes that have been largely unexamined in current scholarship.

Wednesday, September 17, 2014 | 8:10 a.m. – Thursday, September 18, 2014 | 1:30 p.m.
Third international conference on housing risk: New risk measures and their applications

We invite you to join us for this year’s international conference on housing risk — cosponsored by the Collateral Risk Network and AEI International Center on Housing Risk — which will focus on new mortgage and collateral risk measures and their applications.

Event Registration is Closed
Thursday, September 18, 2014 | 2:15 p.m. – 3:00 p.m.
Speaker of the House John Boehner on resetting America’s economic foundation

Please join us as Speaker John Boehner (R-OH) delivers his five-point policy vision to reset America’s economy.

Event Registration is Closed
Friday, September 19, 2014 | 9:15 a.m. – 11:00 a.m.
Reforming Medicare: What does the public think?

Please join us as a panel of distinguished experts explore the implications of the report and the consumer role in shaping the future of Medicare.

No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.