Supervisory enforcement actions against banks and systemic risk

Abstract

Bank prudential supervision is designed to enhance financial stability, but we are unaware of extant empirical research linking this supervision to financial system risk. In particular, there are no prior findings on how supervision enforcement actions (EAs) – major tools of supervisors – affect systemic risk. We empirically investigate relations between EAs and banks’ contributions to systemic risk. We find significantly smaller bank contributions to systemic risk after EAs than before them, suggesting that EAs are associated with enhanced financial stability. The data also suggest that the primary channel behind this relation is reduced leverage, but lower portfolio risk also plays a role. We also find that the magnitude of our findings is greater during financial crises than normal times, and that more severe EAs and EAs against banks are more effective in systemic risk reduction than that are those less severe and those against individual bank managers, respectively.