The Death of a Regulator: Strict Supervision, Bank Lending, and Business Activity

Abstract

An important question in banking is how strict supervision affects bank lending. Supervisors forcing banks to recognize losses could choke off lending and amplify local economic woes. But strict supervision could also change how banks assess and manage loan portfolios and credit risk. Estimating such effects is challenging. We exploit the extinction of the thrift supervisor (OTS) to analyze the effects of strict supervision on bank lending and bank management. We first show that the OTS replacement indeed resulted in stricter supervision of former OTS banks. Next, we analyze the ensuing lending effects and show that former OTS banks on average increase small business lending by roughly 10 percent. This increase is concentrated in well-capitalized banks and especially those that changed bank management practices following the supervisory transition. We also show that the supervisory-induced increase in credit supply is not fully explained by a reallocation from mortgage to small business lending after the crisis and does reflect risk shifting to cope with shrinking margins. These findings suggest that stricter supervision operates not only through capital but can also correct deficiencies in bank management and lending practices, extending credit supply.