Understanding Bank Supervisors’ Risk Assessments: The Influences of Market Conditions and Supervisory Standards

44 Pages Posted: 29 Nov 2011

See all articles by John O'Keefe

John O'Keefe

Independent Consultant

James A. Wilcox

University of California, Berkeley - Economic Analysis & Policy Group; National Bureau of Economic Research (NBER)

Date Written: June 21, 2011

Abstract

A recurring criticism of U.S. bank supervisors is that their standards vary procyclicly with banking and economic conditions. Academic studies of the causes of U.S. banking crises report lapses in bank oversight caused by a pre-crisis period of greater risk tolerance by supervisors. Conversely, post-crisis periods are marked by bankers’ claims of overzealous supervision and tightening of supervisory standards. The 2010 reforms of supervisory standards for bank capital adequacy and liquidity (Basel III) directly address procyclicality in supervision and its effects on credit cycles.

We revisit the question of procyclicality in bank supervisors’ standards and find mixed support for the Basel III reforms. Using data on bank supervisors’ safety and soundness assessments of all U.S. FDIC-insured banks between March 1985 and December 2010, as well as information on banks’ financial and macroeconomic conditions, we develop a model of supervisors’ risk assessments of banks — Ratings Rule Model. We use the Model to examine the relationships between changing risk assessments of banks by their supervisors, bank conditions and economic conditions. Specifically, we estimate the marginal effects of changes in explanatory variables of the Ratings Rule Model on banks’ likelihood of receiving high (low) supervisory ratings. We next analyze the marginal effects and test for significant changes in effects between stressful and non-stressful periods for banking markets.

Our analysis of the Ratings Rule Model suggests that bank supervisors’ risk assessments have been procyclical in some respects. We find evidence that supervisors’ standards for capital adequacy under pillar II of the Basel Accord have been procyclical in the past — becoming more stringent during periods of banking market stress and less stringent during non-stressful periods. In addition, these changes in supervisory risk tolerances for equity capitalization appear to have had a greater impact on risk assessments of sound, well-managed banks than on weak, poorly managed banks. We find, however, that supervisory standards for capital adequacy did not become more stringent during the current financial crisis (2007–2010). Finally, supervisors’ attitude toward other categories of risk — asset quality, earnings strength, and liquidity — appear to be somewhat countercyclical.

In addition to presenting new information on supervisory standards during the current financial crisis, we believe this is the first paper to analyze cyclicality in supervisory standards using the marginal effects of risk factors on banks’ likelihood receiving high (low) supervisory ratings. Hence, we believe this is the first paper to present evidence on the treatment of different risk factors — capital adequacy, asset quality, earnings strength, liquidity and sensitivity to market risk — by supervisors across different types of banks and over banking market cycles.

Keywords: Bank Supervision, Early Warning systems, Credit Cycles

JEL Classification: G21, G28, E32, E44

Suggested Citation

O'Keefe, John and Wilcox, James A., Understanding Bank Supervisors’ Risk Assessments: The Influences of Market Conditions and Supervisory Standards (June 21, 2011). Available at SSRN: https://ssrn.com/abstract=1966101 or http://dx.doi.org/10.2139/ssrn.1966101

John O'Keefe (Contact Author)

Independent Consultant ( email )

James A. Wilcox

University of California, Berkeley - Economic Analysis & Policy Group ( email )

Berkeley, CA 94720
United States
510-642-2455 (Phone)
510-643-1420 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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