Banks can choose their own regulators, but their motives are not always pure, new MU study finds

August 19th, 2019

COLUMBIA, Mo. – When new banks form, the board of directors can choose one of three federal regulators to oversee them. Since each regulatory agency has a distinct level of stringency, this practice allows banks to influence the level of oversight they receive.

While it might seem like banks would choose the least stringent regulator, new research from the University of Missouri suggests that many boards view the choice of regulator as an opportunity to strengthen their bank’s reputation by creating the appearance of a high level of oversight that might not exist.

“Many new banks, regardless of their internal risk management, choose to be regulated by the most stringent regulator,” said Karen Schnatterly, the Emma S. Hibbs Distinguished Professor of Management in MU’s Trulaske College of Business. “Our study indicates that this risk management by bank boards has an unintended side effect: banks seen as less risky might choose a more stringent regulator believing that they will actually be less scrutinized. This way, they gain the reputational benefit of a strong regulator without the added oversight.”

Schnatterly and her colleagues took a random sample of 600 banks formed between 1992 and 1998, analyzing the independence of their boards and their choice of regulators. In order of most to least stringent, banks chose one of the following regulators: the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve or the Office of the Comptroller of the Currency (OCC).

Researchers found that the level of independence in a board of directors directly affected the choice of regulator, with the least independent boards choosing the strongest regulators and vice-versa. However, this effect was significantly weaker for independent boards, indicating they still choose strong regulators despite the low risk of financial violations by their boards.

“Less independent boards choose stronger regulation to ensure their bank has a good reputation that counters their perceived risk,” Schnatterly said. “It’s natural to assume that the inverse is also true: independent boards choose weaker regulation because they are already doing a good job of oversight on their own. But while this is true, many banks with independent boards are also choosing strong regulation, which suggests they see reputational value in a strong regulator and may not believe they will be as closely scrutinized as a less risky bank.”

Schnatterly said the results of the study have implications for the regulatory process, as banks could be choosing a more stringent regulator in order to disguise risky behavior. This effect might become more pronounced as caseloads continue to increase for the more stringent regulatory agencies, which could force them to focus oversight on the most risky institutions, Schnatterly said.