Observing Enforcement: Evidence from Banking

Finance and Economics Discussion Series

Divisions of Research & Statistics and Monetary Aairs

Federal Reserve Board, Washington, D.C.

Observing Enforcement: Evidence from Banking

Anya Kleymenova, Rimmy E. Tomy

2021-049

Please cite this paper as:

Kleymenova, Anya, and Rimmy E. Tomy (2021). Observing Enforcement: Evidence from

Banking," Finance and Economics Discussion Series 2021-049. Washington: Board of Governors of the Federal Reserve System, https://doi.org/10.17016/FEDS.2021.049.

NOTE: Sta working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research sta or the Board of Governors. References in publications to the Finance and Economics Discussion Series (other than acknowledgement) should be cleared with the author(s) to protect the tentative character of these papers.

Observing Enforcement: Evidence from BankingI

Anya Kleymenova, Rimmy E. Tomy

July 27, 2021

Abstract

This paper nds that the disclosure of supervisory actions is associated with changes in regulators' enforcement behavior. Using a novel sample of enforcement decisions and orders (EDOs) and the setting of the 1989 Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA), which required the public disclosure of EDOs, we nd that U.S. bank regulators issue more EDOs, intervene sooner, and rely more on publicly observable signals after the disclosure regime change. The content of EDOs also changes, with documents becoming more complex and boilerplate. Our results are stronger in counties with higher news circulation, indicating that disclosure plays an incremental role in regulators' changing behavior. We evaluate the main potentially confounding changes around FIRREA, including the S&L crisis and competition from thrifts, and nd robust results. We also study changes in bank outcomes following the regime change and nd that uninsured deposits decline at EDO banks, especially for banks with EDOs covered in the news. Finally, we observe that bank failure accelerates despite improvements in capital ratios and asset quality.

JEL Classication: G21, G28

Keywords: Disclosure, Enforcement actions, Regulatory incentives, Banking

• We thank Anat Admati, Rich Ashton, Karthik Balakrishnan, Ray Ball, Anne Beatty, Phil Berger, Daniel Bens, Robert Bushman, Nicola Cetorelli, Hans Christensen, Filippo De Marco (discussant), Doug Diamond, Linda Goldberg, Nargess Golshan (discussant), Yadav Gopalan (discussant), Jason Gonzalez, Jo~ao Granja, Luzi Hail, Beverly Hirtle, Warren Hrung, Kathleen Johnson, Anil Kashyap, Urooj Khan (discussant), Bernard Kim, Ralph Koijen, Tim Kooijmans (discussant), Anna Kovner (discussant), Christian Leuz, Stefan Nagel, Valeri Nikolaev, Kathy Petroni (discussant), Raghuram Rajan, Sugata Roychowdhury (discussant), Thomas Ruchti (discussant), Stephen Ryan, Haresh Sapra, Doug Skinner, Abbie Smith, James Vickery, David Williams, Regina Wittenberg Moerman, and the participants of the seminars at INSEAD, the University of Chicago Accounting Research Workshop, the Federal Reserve Bank of New York, the University of Arizona, UIUC Young Scholars Symposium, the University of Chicago Banking Workshop, London Business School Accounting Symposium, 2019 NBER Summer Institute, Federal Reserve Bank of St. Louis/IU Workshop on Financial Institutions, IIMB Accounting Research Conference, 2019 AAA Annual Meeting, the FDIC/JFSR 19th Annual Bank Research Conference, Berlin Accounting Workshop 2019, Kellogg School of Management, Frankfurt School of Finance and Management, 2019 AAA Midwest Region Meeting, USC, 2019 Knut Wicksell Conference on Financial Intermediation, Ohio State University, 2019 Sydney Banking and Financial Stability Conference (winner of The Bureau Van Dijk Best Paper Award for Banking), the Federal Reserve Board of Governors, and 2020 FARS Midyear meeting for their helpful comments and suggestions. The paper also received the 2020 EFA Institutions and Markets best paper award (sponsored by Oklahoma State University). We are grateful to Byeongchan An, Nobuyuki Furuta, Owen Karpf, James Kiselik, Diana Saakyan, Michelle Skinner, Nitya Somani, and Jason Yang for excellent research assistance. We gratefully acknowledge the nancial support of the Fama-Miller Center for Research in Finance and the University of Chicago Booth School of Business. Anya Kleymenova gratefully acknowledges the support of the FMC Faculty Research Fund at the University of Chicago Booth School of Business. Rimmy E. Tomy gratefully acknowledges the support of the Kathryn and Grant Swick Faculty Research Fund at the University of Chicago Booth School of Business. This paper was previously titled Regulators' Disclosure Decisions: Evidence from Bank Enforcement Actions." The views expressed in this study are those of the authors and do not necessarily reect the views of the Federal Reserve Board or the Federal Reserve System.

• Federal Reserve Board, 20th Street and Constitution Avenue NW, Washington, DC 20551;
  [e-mail]
  Corresponding author: The University of Chicago Booth School of Business, 5807 South Woodlawn Avenue, Chicago, IL 60637; [e-mail]

There is now a widespread consensus on the need for regulation, but that still leaves open the question: even if we have good regulations, how do we ensure that they will be enforced? How do we prevent regulatory failure?

|Joseph Stiglitz, in Regulation and Failure" (Stiglitz, 2009)

1. Introduction

We study whether the required disclosure of regulators' supervisory actions is associated with changes in their enforcement behavior. This sort of disclosure could either increase or decrease regulatory strictness. It could increase strictness by impacting regulators' reputation and credibility. Disclosure increases the costs of forbearance; therefore regulators concerned about their reputation and career prospects might become stricter when their supervisory actions receive public scrutiny (Holmstrom , 1999). On the other hand, disclosure might lead regulators to take less aggressive actions. Bank regulators might be concerned with how disclosing enforcement actions aects nancial stability, in particular the likelihood of bank runs, and reduces risk-sharing opportunities (Diamond & Dybvig, 1983; Goldstein

• Leitner, 2018; He & Manela, 2016; Morris & Shin, 2002). They might also want to ward o lawsuits from regulated rms and ensure their continued cooperation.1
  Although prior literature studies the impact disclosure of supervisory actions has on regulated entities, limited empirical evidence exists on the eects of disclosure on regulators because regulators' actions are generally unobservable in a nondisclosure regime (Anbil, 2018; Docking et al., 1997; Jin & Leslie, 2003; Slovin et al., 1999). We address this empirical challenge by exploiting the 1989 Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA), which, among other changes, required U.S. banking regulators to publicly disclose their enforcement actions against banks.
  Enforcement actions (ocially referred to as enforcement decisions and orders or EDOs)

1We provide examples of banks suing regulators in the online appendix. Banks also have the right to contest regulators' decision to issue an EDO before an administrative law judge (see Section 2 and Appendix A).

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are an important regulatory tool that bank regulators and supervisors use to require a bank to take corrective actions (Curry et al., 1999; Eisenbach et al., 2017; Hirtle et al., 2020). Noncompliance with an EDO is a serious oense that could lead to monetary penalties or the withdrawal of deposit insurance. Although bank regulators have issued enforcement actions since 1966, contemporaneous information on these actions has been publicly disclosed only since the August 9, 1989, passage of FIRREA.

To study the eects of the change in the disclosure regime on regulatory incentives, a researcher must observe enforcement actions before and after the regime change, even though EDOs issued before were never disclosed by the regulators. A key feature of our study is that we identify enforcement actions in the pre-FIRREA regime by using termination documents that were released following the regime change. From the U.S. National Archives, we also hand-collect a subset of enforcement actions for 1983{1984 that terminated during the pre- disclosure period. Unlike the post-FIRREA actions, the pre-FIRREA EDOs were not public. Therefore this setting and our sample allow us to study changes in regulators' behavior once their actions become observable. A drawback of our sample is that, apart from the hand- collected observations, our pre-disclosure sample consists of enforcement orders that were initiated prior to FIRREA and terminated afterward. This likely results in some missing observations in the earlier part of the 1985{1989 sample for EDOs that were initiated and resolved prior to FIRREA. Our sample for 1983{1984 partially alleviates this concern, as it has a similar distribution of EDO length as the post-FIRREA sample (Figure 1).

We begin our analyses by investigating the likelihood of banks' receiving an enforcement action in the two regimes. Once enforcement actions are observable, we nd regulators become stricter, as evidenced by intervening more and, conditional on intervening, issuing enforcement actions sooner. Publicly observable signals are also more strongly associated with EDOs after the change in disclosure regime. For instance, we nd banks' nonperform- ing assets, capital ratio, and protability play a more signicant role in regulators' decisions to issue enforcement actions after the regime change. We also observe that, conditional

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on intervening, regulators issue EDOs 71% sooner in the disclosure regime, relative to the nondisclosure regime. Next, we evaluate whether the content of enforcement actions changes following the disclosure regime change. Prior studies have documented that regulators facing increased public scrutiny make their disclosures less informative and more standardized (Meade & Stasavage, 2008; Hansen et al., 2017). In our content analyses, we likewise nd that EDOs become longer, more complex, and include more boilerplate language after the regime change. These results suggest that the disclosure regime change is associated with changes in regulators' actions.

FIRREA was passed toward the end of the thrift crisis and included other changes to regulatory enforcement. Therefore the disclosure of EDOs was not the only provision that aected regulators' actions but rather one of several contributors. To tie our ndings to the disclosure channel, we use variation in news circulation across counties. We argue that regulators' cost of not issuing enforcement actions is higher in counties with higher news circulation because banks' funding providers are more likely to be aware of issues at their banks through news coverage. Therefore regulators' credibility and reputation would be harmed if they do not issue timely enforcement actions. In addition, market discipline is likely to work better in counties with higher news circulation because funding providers are more likely to learn about EDOs. Consequently, we expect the marginal benet of regulators' disclosing enforcement actions to be higher in counties with higher news circulation, leading regulators to issue more enforcement actions to problem banks in these counties. Even though depositors are more likely to learn about EDOs in higher news circulation counties and withdraw their deposits from aected banks, regulators trade o the possibility of a run against their credibility. Consistent with these arguments, in counties with higher news circulation, we nd regulators are 40% more likely to issue enforcement actions in the disclosure regime than in the nondisclosure regime. We also nd regulators intervene sooner in counties with higher news circulation. These ndings suggest that the disclosure regime change plays an important role in observed changes in regulatory behavior.

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