Supervisory Effectiveness and Bank Risk

Abstract

This paper investigates the role of banking supervision, measured in terms of enforcement outputs (i.e. on-site audits and sanctions), in containing bank risk-taking. First, a direct relationship is considered, while the combined effect of effective supervision and banking regulation in the form of capital and transparency requirements is analyzed thereafter. As far the former is concerned, an inverted U-shaped relationship is established between on-site audits and bank risk, whilst the correlation between enforcement actions and risk is found to be linear and negative. With respect to the latter, we find that effective supervision and disclosure requirements are important and complementary mechanisms in reducing bank risk, by contrast to capital requirements that are proven rather futile in controlling bank risk, even when supplemented with a higher volume of on-site audits and enforcement actions.

Keywords: Bank risk, Regulation, Supervision, Enforcement, Sanctions, Audits

JEL Classification: G21, G32, G38