The Impact of Strengthening Regulatory Surveillance on Bank Behavior: A Dynamic Analysis

The financial crisis from 2007 to 2009 ignited discussions on the necessity of reforming bank regulations. The inadequacy of pre-crisis microprudential policies to manage significant financial shocks became evident. In response, the Basel III regulations emerged, advocating for increased bank capital requirements. This study investigates the effects of enhancing bank capital supervision on bank behavior, particularly focusing on the transition from incomplete enforcement to complete enforcement of regulations. The research emphasizes the importance of monitoring bank capital conditions as a proactive measure to mitigate the financial burden of bank bailouts on governments. By analyzing the impact of regulatory changes on bank heterogeneity in lending, capital accumulation, and default decisions, the study contributes to both theoretical and empirical literature on microprudential regulation. The findings underscore the necessity of adapting regulatory frameworks to ensure the stability of the banking system.

The study develops a dynamic model that incorporates the concept of incomplete enforcement of regulations. It posits that certain banks may opt not to comply with regulations based on the likelihood of inspections and the severity of penalties. The model explicitly defines the regulatory pressure exerted by financial agencies, represented as the probability of inspections leading to the detection of regulatory violations. Unlike previous models that treat capital regulation as strictly binding, this framework allows for the possibility of occasionally binding capital requirements. This flexibility enables banks to build capital buffers beyond the mandated levels, driven by precautionary motives. The introduction of prompt corrective action (PCA) policies serves as a pivotal point in the analysis, illustrating how regulatory pressure influences bank behavior and capital accumulation strategies. The model's insights reveal the critical role of regulatory frameworks in shaping bank responses to capital requirements.

To validate the theoretical model, the study employs empirical methods, utilizing data from the introduction of PCA in Japan as a natural experiment. The analysis examines the short-run implications of strengthened regulatory surveillance on bank behavior. Findings indicate that banks respond to increased regulatory pressure by enhancing their capital buffers, thereby reducing the likelihood of regulatory violations. The empirical evidence aligns with the theoretical predictions, demonstrating that stricter surveillance leads to improved compliance with capital requirements. The study also highlights the significance of heterogeneous bank models in understanding the diverse responses of banks to regulatory changes. By analyzing bank-level data, the research provides valuable insights into the dynamics of bank behavior under varying regulatory conditions, emphasizing the practical applications of the findings in shaping future regulatory policies.

The research underscores the importance of strengthening regulatory surveillance to enhance bank stability and compliance with capital requirements. The findings suggest that effective regulatory frameworks can mitigate the risks associated with credit crunches and promote a more resilient banking system. Policymakers are encouraged to consider the implications of the study when designing regulations that address the complexities of bank behavior. The insights gained from the analysis can inform future regulatory reforms, ensuring that they are adaptable to the evolving landscape of the financial sector. Ultimately, the study contributes to a deeper understanding of the interplay between regulatory practices and bank behavior, offering a foundation for ongoing discussions on improving microprudential policies.