Observing Enforcement: Evidence from Banking

• Published date: 01 September 2022
• Author: ANYA KLEYMENOVA,RIMMY E. TOMY
• Date: 01 September 2022
• DOI: http://doi.org/10.1111/1475-679X.12422

DOI: 10.1111/1475-679X.12422

Journal of Accounting Research

Vol. 60 No. 4 September 2022

Printed in U.S.A.

Observing Enforcement: Evidence

from Banking

ANYA KLEYMENOVA∗AND RIMMY E. TOMY†

Received 8 July 2020; accepted 26 December 2021

∗Federal Reserve Board; †The University of Chicago Booth School of Business

Accepted by Luzi Hail. We thank two anonymous referees, Anat Admati, Rich Ashton, Ray

Ball, Anne Beatty, Phil Berger, Robert Bushman, Nicola Cetorelli, Hans Christensen, Anna

Costello, Filippo De Marco (discussant), Doug Diamond, Linda Goldberg, Nargess Golshan

(discussant), Yadav Gopalan (discussant), Jason Gonzalez, João Granja, Beverly Hirtle, War-

ren Hrung, Kathleen Johnson, Anil Kashyap, Urooj Khan (discussant), Ralph Koijen, Tim

Kooijmans (discussant), Anna Kovner (discussant), Christian Leuz, Michael Minnis, Valeri

Nikolaev, Kathy Petroni (discussant), Raghuram Rajan, Sugata Roychowdhury (discussant),

Thomas Ruchti (discussant), Stephen Ryan, Haresh Sapra, Doug Skinner, Abbie Smith, Rahul

Vashishtha (discussant), James Vickery, David Williams, Regina Wittenberg Moerman, and

the participants of the seminars at INSEAD, the University of Chicago Accounting Research

Workshop, the Federal Reserve Bank of New York, the University of Arizona, UIUC Young

Scholars Symposium, the University of Chicago Banking Workshop, London Business School

Accounting Symposium, 2019 NBER Summer Institute, Federal Reserve Bank of St. Louis/IU

Workshop on Financial Institutions, IIMB Accounting Research Conference, 2019 AAA An-

nual Meeting, the FDIC/JFSR 19th Annual Bank Research Conference, Berlin Accounting

Workshop 2019, Kellogg School of Management, Frankfurt School of Finance and Manage-

ment, 2019 AAA Midwest Region Meeting, USC, 2019 Knut Wicksell Conference on Financial

Intermediation, Ohio State University, 2019 Sydney Banking and Financial Stability Confer-

ence (winner of The Bureau Van Dijk Best Paper Award for Banking), the Federal Reserve

Board of Governors, 2020 FARS Midyear meeting, and FRB External Webinar for their help-

ful comments and suggestions. The paper also received the 2020 EFA Institutions and Markets

best paper award. We are grateful to Byeongchan An, Nobuyuki Furuta, Owen Karpf, James

Kiselik, Diana Saakyan, Michelle Skinner,Nitya Somani, and Jason Yang for excellent research

assistance. We gratefully acknowledge the financial support of the Fama-Miller Center for Re-

search in Finance and the University of Chicago Booth School of Business. Anya Kleymenova

gratefully acknowledges the support of the FMC Faculty Research Fund at the University of

Chicago Booth School of Business. Rimmy E. Tomygratefully acknowledges the support of the

Kathryn and Grant Swick Faculty Research Fund at the University of Chicago Booth School

of Business. The views expressed in this study are those of the authors and do not necessarily

reflect the views of the Federal Reserve Board or the Federal Reserve System. An online ap-

pendix to this paper can be downloaded at http://research.chicagobooth.edu/arc/journal-

of-accounting-research/online- supplements

1583

© 2022 The Chookaszian Accounting Research Center at the University of Chicago Booth School of

Business.

1584 a. kleymenova and r. e. tomy

ABSTRACT

This paper finds that the disclosure of supervisory actions by bank regulators

is associated with changes in their enforcement behavior. Using a novel sam-

ple of enforcement decisions and orders (EDOs) and a change in the disclo-

sure regime, we find that regulators issue more EDOs, intervene sooner, and

rely more on publicly observable signals following the regime change. EDO

documents become longer, more complex, and contain more boilerplate lan-

guage. Our results also indicate that intervention happens sooner and more

frequently in counties with higher news circulation, which suggests that reg-

ulators take into account the public perception of their actions. We evaluate

potentially confounding factors, including the savings and loan (S&L) crisis

and competition from thrifts, and find robust results. We also study bank out-

comes and document that uninsured deposits decline at EDO banks in the

disclosure regime, especially for those covered in the news. Finally, we ob-

serve that bank failure accelerates despite improvements in capital ratios and

asset quality. Overall, our research provides new insights on the disclosure of

regulatory actions.

JEL codes: E44, E58, G21, G28, G38, K23, L51, M41, M48, N20, N22

Keywords: banking; banking supervision; depository institutions; dis-

closure regulation; enforcement actions; market discipline; regulatory

incentives

There is now a widespread consensus on the need for regulation, but that still leaves

open the question: even if we have good regulations, how do we ensure that they will

be enforced? How do we prevent regulatory failure?

—Joseph Stiglitz, in “Regulation and Failure” (Stiglitz [2009])

1. Introduction

We study whether the disclosure of regulators’ actions is associated with

changes in their enforcement behavior. Regulators concerned about their

reputation and career prospects might become stricter and intervene more

when their supervisory actions receive public scrutiny (Holmström [1999]).

However, disclosure could also reduce regulators’ incentives to intervene

because they might want to avoid lawsuits from regulated firms and ensure

these firms’ continued cooperation. Specific to the banking sector, disclo-

sure could deteriorate financial stability and reduce risk-sharing opportu-

nities (Diamond and Dybvig [1983], He and Manela [2016], Goldstein and

Leitner [2018], Morris and Shin [2002]).

Although prior literature studies the impact of disclosure on regulated

entities, limited empirical evidence exists on the effects of disclosure on

observing enforcement 1585

the actions of regulators, which are generally unobservable in a nondis-

closure regime (Docking, Hirschey, and Jones [1997], Slovin, Sushka, and

Polonchek [1999], Jin and Leslie [2003], Anbil [2018]). We address this

observability issue by exploiting the Financial Institutions Reform, Recov-

ery, and Enforcement Act of 1989 (FIRREA), which, among other changes,

required U.S. banking regulators to publicly disclose enforcement actions

against banks. Banking regulators and supervisors use enforcement actions

(referred to as enforcement decisions and orders, or EDOs) to require a

bank to take corrective actions (Curry et al. [1999], Eisenbach et al. [2017],

Hirtle, Kovner, and Plosser [2020]). Noncompliance with an EDO could

lead to monetary penalties or even the withdrawal of deposit insurance. Al-

though bank regulators have issued enforcement actions since 1966, these

actions have been publicly disclosed only since the August 9, 1989, passage

of FIRREA.

To study the effects of the change in the disclosure regime on regulators’

incentives, a researcher would need to observe enforcement actions before

and after the regime change. A key feature of our study is that we identify

enforcement actions in the nondisclosure regime using two sets of docu-

ments. First, we utilize documents that were released following the regime

change. These documents contain information on EDOs that were issued

in the nondisclosure regime but terminated after the regime change. Sec-

ond, we hand-collect a subset of enforcement actions that were issued and

terminated during the nondisclosure period. Unlike the post-FIRREA ac-

tions, the pre-FIRREA EDOs were not public. Therefore this setting and

our sample allow us to study changes in regulators’ behavior once their

actions become publicly observable.

We begin by investigating the likelihood of regulators issuing enforce-

ment actions in the two regimes. We find regulators become stricter once

enforcement actions are observable, as evidenced by their increased inter-

vention. Conditional on intervention, regulators also issue enforcement

actions more quickly. Bank characteristics, such as capital ratio and prof-

itability, which are publicly observable, are also more strongly associated

with EDOs after the change in disclosure regime. We further evaluate

whether the content of enforcement actions changes following the regime

change. Prior studies have documented that regulators facing increased

public scrutiny make their disclosures less informative and more standard-

ized (Meade and Stasavage [2008], Hansen, McMahon, and Prat [2017]).

Consistent with these studies, our content analyses indicate that after the

regime change, EDO documents become longer and more complex and

include more boilerplate language. These results suggest that the disclo-

sure regime change is associated with changes in regulators’ actions.

To tie our findings to the disclosure channel, we use variation in news

circulation across counties. In counties with higher news circulation, reg-

ulators bear higher costs of not issuing enforcement actions because fund-

ing providers are more likely to be aware of issues at the banks involved.

EDOs are a warning signal and bank failure without this signal would