The Value of Regulators as Monitors: Evidence from Banking

Abstract

While conventional wisdom suggests that regulation is costly for shareholders, agency theory predicts a positive role for regulation in reducing shareholder monitoring costs. I study this trade-off by exploiting an unexpected decrease in small-bank supervision by the Federal Reserve, and I find that reduced Fed supervision leads to a 1% loss in bank Tobin’s q and a 7% loss in equity market-to-book. These losses come from increased monitoring expenditures and managerial misreporting, and are larger when bank cash flows are volatile and opaque. My results highlight a novel substitution effect between public monitoring by regulators and private monitoring by shareholders.