Supervisory Incentives in a Banking Union

We study the consequences for supervisors’ and banks’ behavior of a “hub-and-spokes” supervisory system where a centralized agency has authority over banks but relies on local supervisors to collect actionable information. The model entails a principal-agent problem between central and local supervisors that leads to tougher supervisory standards but less compliance on the side of the supervised banks. Centralization entails greater inspection effort by the local supervisor and less bank risk taking if the divergence in the intervention policy of the central and the local supervisors is sufficiently small, but less effort and riskier bank portfolios if the divergence is large. The model has implications for the design of supervisory frameworks within integrated economies. This paper was accepted by Karl Diether, finance.