The Performance Effects of Regulatory Oversight Kristin Wilson and Stan Veuger Harvard Business School & Harvard University Presentation for SBE / ARCS Conference May 10, 2011
Firms have a range of options in engaging with their regulators… Increasing engagement Arms-Length Collaborative Managers report that they feel ineffective building “strong trust -based relationships” with key government stakeholders 73% 27% Not Effective Effective Managers disagree on whether enforcement relationships contribute positively or negatively to firm value 41% 44% Positive Negative
How does regulatory engagement affect firm performance? Arms-Length Collaborative Collude with regulator Evade resource-constrained regulator Capitalize on regulator’s lower monitoring costs Increase costs of rent-seeking for managers and bureaucrats Reduce uncertainty about enforcement environment Knowledge transfer
How does regulatory engagement affect firm performance? Cost of compliance Q1: Does increasing regulatory engagement increase the administrative burden of compliance? No. Compliance levels Q2: Does increasing regulatory engagement increase compliance? No. Knowledge transfer Q3: Does increasing regulatory engagement increase firms’ operational efficiency? Yes.
Application to US Commercial Banking Regulation Capital controls and reporting requirements Oversight Periodic on- site exams for “Safety and Soundness” Loan-level analysis Management evaluation Examiner discretion Highly confidential Continuous monitoring between exams
Measuring engagement We need a proxy for engagement with regulators that is not endogenous to financial performance … We use physical distance as an exogenous measure of cost of engagement between firms and regulators Travel time (minutes) Regulator Field Office (FO) Bank Headquarters (HQ)
Support for use of distance proxy 1. Economic geography literature 2. Evidence from examination frequency 3. Evidence that supervisors perceive proximity as lowering barriers to engagement
Support for use of distance proxy 1. Economic geography literature Physical proximity facilitates information exchange, knowledge transfer, relational contracting (Rajan & Petersen, 2002; Coval & Moskowitz, 2002; Malloy, 2005) Physical distance increases monitoring costs (Kedia & Rajgopal, 2011; DeFond, Francis & Hu, 2011) 2. Evidence from examination frequency 3. Evidence that supervisors perceive proximity as lowering barriers to engagement
Support for use of distance proxy 1. Economic geography literature 2. Evidence on examination frequency Period between exams 3 months longer for banks 2 hours more distant, controlling for bank characteristics Discretionary variation in between-exam periods is 12 months 3. Evidence that supervisors perceive proximity as lowering barriers to engagement
Support for use of distance proxy 1. Economic geography literature 2. Evidence on examination frequency 3. Evidence that supervisors perceive proximity as lowering barriers to engagement “Because state banks in Tennessee have closer geographical proximity to their primary regulator, communication is more direct and more effective …any institution may call staff members or the commissioner with questions or concerns and get a personal audience quickly . We encourage…close contact with us; no problem is deemed unimportant.” Tennessee Department of Financial Institutions
Problems with distance proxy Omitted variables 1. Endogeneity of location choice 2. … we address both of these concerns through our empirical approach
Empirical Approach: Overview Question DV Q1 Is increasing supervisor distance associated with higher Admin administrative burden? Costs Q2 Are differences in performance due to risk-taking at Leverage, distant banks? NPL, NIM What is the net effect on performance? ROE … followed by discussion of evidence on efficiency gains at co -located banks (Q3) and additional evidence to support conclusions
Empirical Approach: Data Sample: US Commercial Banks, 2001-2009 Unbalanced panel, around 3,500 banks per year Bank size between $100 Million and $10 Billion Predominantly community / regional banks Excludes rural banks Excludes AK, HI, RI, DC Sources Financial data - Call Reports Local area data - BEA, BLS, Census Distance measured between banks and regulators using ArcMap
Multiple regulators Division of power between federal and state authorities Banks select into one of three supervision regimes Institution type Supervision National Banks (NB) OCC State Member Banks (SB-M) State Authorities (SBA) Federal Reserve Bank State Non-Member Banks (SB-NM) State Authorities (SBA) FDIC
Map of Regulatory Agency Offices (FRS)
Map of Regulatory Agency Offices (FRS + FDIC)
Map of Regulatory Agency Offices (FRS + FDIC + OCC)
Map of Regulatory Agency Offices (FRS + FDIC + OCC + SBA)
Empirical Approach: Identification SBA FDIC MSA 45 minutes 20 minutes National State Bank Bank 120 minutes FRS 60 minutes OCC
Econometric Specification X: Dependent Variables : Firm Characteristics Admin Costs % Capital Portfolio Composition ROE Economic environment Leverage MSA fixed effects NPL ratio Field office fixed effects Net Interest Margin
Empirical Approach: Controls Firm Controls Portfolio Composition Age Asset size BHC indicator % Cash, Earning assets, Loans “Main enterprise” Loan portfolio weights Acquisition history % Deposits SEC registration Leverage, RWA ratio Foreign Indicator NPL ratios, Capital adequacy ratio
Empirical Approach: Controls Economic Environment Fixed Effects Unemployment rate Year Unemployment growth MSA (headquarters) Labor force growth Field office Average local market share Average local HHI State exposure All indicators deposit weighted at MSA/county-level and aggregated to institution level
Endogeneity concerns Key Variable = Agency Choice i,t * Distance to Agency i,t Agency choice Instruments : indicator for geographically closest field offices; state land area (sq mi) Distance to Agency Large multi-state banks are excluded from sample, banks to regional deposit base Highly stable location (bank and FO), so MSA fixed effects should minimize this concern
Administrative burden …is higher at distant banks Costs as a percentage of capital Admin (includes legal, auditing, Costs telecommunications, data, consulting and insurance fees) ( b ) Distance to OCC x National Bank 0.0131*** Distance to SBA x State Bank 0.0067 Distance to FDIC x State Non-Member 0.0100** Distance to FRS x State-Non Member 0.0069 Total distance, firm-level, portfolio, and market controls included. MSA, State, FO Fixed Effects included. Observations: 23,020
Evasion? Evidence of Risk-taking Leverage does not vary within regime Non-performing loans (NPL) do not vary within regime Net interest margin (NIM) same or lower at more distant banks … implying that more distant banks experience lower returns without any offsetting benefits
Administrative burden … results in reduced profitability Cost Ratio ROE ( b ) ( b ) Distance to OCC x National Bank 0.0131*** -0.0116* Distance to SBA x State Bank 0.0067 0.0112 High costs Distance to FDIC x State Non-Member 0.0100** -0.0132** to low ROE Distance to FRS x State-Non Member 0.0069 -0.0058 Total distance, firm-level, portfolio, and market controls included. MSA, State, FO Fixed Effects included. Observations: 23,020
More evidence Knowledge transfer Are co-located banks more efficient? Industry collusion Is this just evidence of “captured” regulators? Banking Crisis (2008-2009) How do industry shocks affect regulatory engagement? Technology trend Does technology adoption reduce the importance of “distance” as a measure of engagement?
Wrap-up In this setting, regulatory engagement has two measurable benefits for firms Lower costs as closer engagement facilitates information exchange Improved use of resources as firms draw on regulatory expertise Evidence of heterogeneous agency behavior Contribution to our understanding of the role of ongoing regulatory relationships in firm performance
“We Should Do This More Often”
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