2017 - 18 Year in Review

26 THE DEATH OF A REGULATOR: STRICT SUPERVISION, BANK LENDING, AND BUSINESS ACTIVITY An important question in banking is how strict supervision affects bank lending and in turn local business activity. Forcing banks to recognize losses could choke off lending and amplify local economic woes, especially after financial crises. But stricter supervision could also lead to changes in how banks assess loans and manage their loan portfolios. Estimating such effects is challenging. We exploit the extinction of the thrift regulator (Office of Thrift Supervision, or OTS)—a large change in prudential supervision, affecting 10 percent of all US depository institutions. Using this event, we analyze economic links between strict supervision, bank lending, and business activity. We first show that the OTS replacement indeed resulted in stricter supervision of former OTS banks. We then analyze the lending effects of this regulatory change and show that former OTS banks increase small business lending by approximately 10 percent. This increase stems primarily from well-capitalized banks and those more affected by the new regime. These findings suggest that stricter supervision not only operates through capital but can also overcome frictions in bank management, leading to more lending and a reallocation of loans. Consistent with the latter, we find increases in business entry and exit in counties with greater exposure to OTS banks. João Granja Assistant Professor of Accounting Christian Leuz Joseph Sondheimer Professor of International Economics, Finance and Accounting