The Effects of Regulatory Office Closures on Bank Behavior

Mon, 01 Jan 0001 00:00:00 +0000

Using closures of U.S. bank regulatory offices between 2002 and 2013 as difference-in-differences shocks to the physical proximity between supervisors and the community banks they oversee, the paper asks whether a decentralized network of local supervisory offices produces safer banks. The authors first show closures are not predicted by the risk or performance of the supervised banks — offices near a regional main office with falling workload are the ones shut — which supports treating closures as plausibly exogenous to affected banks. Following a closure, banks previously supervised by the closed office increase total lending by about 6-10% and tilt toward riskier loans (e.g., commercial real estate), and overall risk-taking as measured by the Z-Score rises by roughly 19-32% of the sample mean, with larger increases in distance to the new office associated with riskier policies. Banks affected before the 2008-09 financial crisis subsequently exhibited more bad loans, higher charge-offs, and higher failure rates during the crisis. Examining channels, the authors find affected banks report lower and less timely loan-loss provisions (and more income-increasing provisions, making balance sheets more opaque), increase dividend payouts, and see lower risk-adjusted returns on assets — which they read as evidence that proximity lets supervisors enforce timelier provisioning, restrain payouts, and share expertise. On balance the authors interpret the results as implying that geographical proximity reduces informational frictions in supervisory monitoring and leads to more stable banks — that is, the monitoring-benefit view dominates the regulatory-capture view on average.

Summary of a forthcoming paper, AI-assisted and human-reviewed. See the linked original for the authoritative claims and full conditions.

In depth

Q1. What is the paper’s research design and identification strategy?

The paper uses a difference-in-differences design built on closures of FDIC, Federal Reserve, and OCC regulatory offices from 2002 to 2013, comparing banks that lost their supervising office to nearby banks in the same county supervised by a different office. Because U.S. banks in the same geographic area may be supervised by one of three federal regulators, within a county where an office closed only banks supervised by that closed office should be affected, while similarly located banks supervised by another office serve as controls exposed to the same local economic conditions. The analysis draws on a hand-collected data set mapping regulatory office locations and focuses on community banks, which are tied to local markets and served by traveling rather than in-house examiners. The tightest specifications include county-quarter, regulatory-office-quarter, and bank fixed effects, and the authors report parallel pre-trends and, using a timing-effects model, effects that appear only after closures and not before.

Q2. Are office closures plausibly exogenous to the affected banks?

The authors report that office closures are unrelated to the risk, performance, assets, or loans of the banks the office supervised; instead, offices closest to a regional main office experiencing a falling workload are the ones closed. They read this as the reasons for closure residing with banks outside the closed office’s immediate vicinity and reflecting a rebalancing of supervisory resources within regions, which they argue alleviates reverse-causality concerns that poor bank performance could drive both office closures and subsequent higher risk-taking.

Q3. What happens to bank lending and risk-taking after a regulatory office closes?

Following a closure, affected banks increase total lending by 6-10% and increase overall risk-taking as measured by the Z-Score by 19-32% of the sample mean, directing new lending toward riskier loan categories such as commercial real estate. In addition, larger increases in physical distance to the new supervising office are associated with riskier policies, which the authors interpret as evidence that proximity alleviates informational frictions in collecting information from and communicating with banks. The paper reports that its analysis does not provide clear evidence that treated banks hold more capital after office closures.

Q4. Do these changes have consequences for bank fragility?

Banks affected by office closures prior to the 2008-09 financial crisis subsequently exhibited more bad loans, higher charge-offs, and were more likely to fail during the crisis. The authors present this as evidence that the additional lending and risk-taking following closures was not benign, and read it, collectively, as support for the view that a decentralized supervisory structure — by keeping supervisors proximate — leaves banks less fragile.

Q5. Through what channels does proximity appear to operate?

The authors examine three nonmutually exclusive channels — provisioning practices, payouts, and supervisory expertise — and report evidence consistent with each. On provisioning, affected banks report both lower and less timely loan-loss provisions and make greater use of income-increasing provisions, which leads to more opaque balance sheets. On payouts, affected banks significantly increase their dividend payouts to shareholders. On expertise, risk-adjusted returns on assets for affected banks decrease after closures, which the authors read as consistent with proximate supervisors advising banks toward more efficient risk-taking. They interpret the combined evidence as proximity reducing informational frictions in supervisory monitoring.

Q6. How do the authors position their contribution and interpret the findings overall?

The authors state that, to the best of their knowledge, they are the first to use regulatory office closures to study how geographical networks of offices matter for bank supervision, and they interpret their results as indicating that the monitoring-benefit view dominates the regulatory-capture view on average. They emphasize that both views — that proximity aids monitoring and that proximity risks capture — can operate simultaneously, so the empirical question is which dominates; the finding of riskier, more fragile banks after supervisors move farther away implies proximity’s monitoring benefits dominate. The paper frames the policy-relevant implication as: geographical proximity reduces informational frictions in supervisory monitoring and leads to more stable banks.

Key concepts

Regulatory office closure : the shutting of a local supervisory office of the FDIC, Fed, or OCC, used here as a shock that increases the physical distance between a community bank and its supervisor while leaving the bank’s regulator and the applicable rules unchanged.

Decentralized supervisory structure : the arrangement whereby a unified body of banking regulation is enforced through geographically dispersed networks of local supervisory offices, intended to give supervisors easier access to local (especially soft) information about banks.

Monitoring-benefit (proximity) view : the hypothesis that physical proximity lowers the cost of collecting soft information and communicating supervisory expectations, enabling supervisors to enforce safer bank policies.

Regulatory capture view : the alternative hypothesis that proximity to supervised banks can undermine monitoring, because closer contact fosters social/communal ties or career concerns that lead supervisors to cater to bank interests.

Loan loss provisions (LLPs) : accounting charges intended to reflect the expected future losses on a bank’s loan portfolio; under-provisioning can flatter short-term liquidity and performance while masking inadequate capital, and the paper finds affected banks report lower and less timely LLPs.

Z-Score : the accounting-based measure of bank risk the paper uses; the paper reports that overall risk-taking, as measured by the Z-Score, increases by 19-32% of the sample mean for banks affected by office closures.

Community banks : smaller banks tied to local markets and served by traveling rather than in-house examiners — the sample the paper focuses on.

Key concepts

Community banks : smaller banks tied to local markets and served by traveling rather than in-house examiners — the sample the paper focuses on.

M41 | Macro Paper Warehouse

The Effects of Regulatory Office Closures on Bank Behavior

In depth

Q1. What is the paper’s research design and identification strategy?

Q2. Are office closures plausibly exogenous to the affected banks?

Q3. What happens to bank lending and risk-taking after a regulatory office closes?

Q4. Do these changes have consequences for bank fragility?

Q5. Through what channels does proximity appear to operate?

Q6. How do the authors position their contribution and interpret the findings overall?

Key concepts

Key concepts