The Effect of Bank Supervision on Risk Taking: Evidence from a Natural Experiment

Abstract

In this paper, we exploit a natural experiment in which thrifts in several states witnessed an exogenous reduction in supervisory attention to assess the effect of supervision on financial institutions' willingness to take risk. We show that the affected institutions took on much more risk than their unaffected counterparts in other districts that were subject to identical regulations. Subsequent to the emergency enlistment of examiners and supervisors from other parts of the country two years later, additional risk taking by the affected thrifts ceased. We find that the expansion in risk taking resulted in a higher incidence of failure as well as more costly failures. None of these patterns are present in commercial banks subject to a different primary supervisory agent but otherwise similar to the thrifts in our sample.