Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Enforcement Actions and Bank Loan Contracting

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Enforcement Actions and Bank Loan Contracting

Article excerpt

Enforcement actions against banks and their management officials, directors, and employees are important supervisory instruments. Regulators issue enforcement actions for violations of laws, rules, or regulations; breaches of fiduciary duty; and unsafe or unsound banking practices. In many cases, enforcement actions provide borrowers with new information about a bank's health, its banking practices, or its treatment of customers that may be difficult to infer from other disclosures.

But enforcement actions can be costly for banks. Affected banks spend resources to correct the problems that enforcement actions identify and are sometimes required to pay fines or make payments to aggrieved parties. In addition, because enforcement actions are publicly announced, they may carry potentially severe reputational costs. These actions can create uncertainty about a disciplined bank's condition or future prospects and, in turn, reduce the demand for credit from the bank. In response, some disciplined banks may offer borrowers lower loan rates and more generous contract terms to compensate for the uncertainty and credibility loss and thereby avoid losing their customers. Alternatively, other disciplined banks may attempt to reduce risk by offering borrowers loans with a higher interest rate and more stringent terms.

In this article, I investigate the effects of enforcement actions on bank loan contracting. My results using loan-level data and multidimensional information on loan contracts have significant implications for disciplined banks. They suggest that loans initiated after enforcement actions have statistically and economically significantly lower interest rates than loans initiated before enforcement actions. The decreases in interest rates are significant for enforcement actions issued against both banks and management officials and are slightly more pronounced for severe enforcement actions.

The results also suggest that other, non-price loan terms-particularly maturity and covenant intensity-become more favorable for borrowers after an enforcement action. In addition, the loan structure changes after enforcement actions: the number of lenders in syndicated loans increases, while transaction fees charged to borrowers decrease. These results are consistent with reduced demand from borrowers leading banks to offer more favorable loan contract terms. Thus, formal enforcement actions may reduce income and increase costs significantly for disciplined banks.

Section I reviews the institutional background on enforcement actions and develops the hypotheses to be tested regarding the relationship between enforcement actions and the cost of bank loans. Section II describes the data and the determinants of the cost of bank loans. Section III conducts an econometric analysis of the relationship between enforcement actions and the cost of bank loans after controlling for other factors. Section III also examines the effects of enforcement actions on other loan contract terms and syndicated lender structure.

I. Regulatory Agencies and Enforcement Actions in the U.S. Banking System

During the 2008 financial crisis, many financial institutions questioned each other's financial liquidity and solvency, causing financial markets to seize up. The crisis highlighted serious regulatory compliance and safety-and-soundness issues at many banks. A recent research report by Srinivas and others shows that the number of regulatory enforcement actions escalated from 500 and 600 per year in the pre-crisis period to 906 in 2008, 1,563 in 2009, and 1,795 in 2010. These numbers demonstrate the prevalence of enforcement actions as regulatory tools to strengthen financial institutions and stabilize the financial system.

Promoting a safe, sound, and stable banking system-as well as a fair and transparent consumer financial services market-are important objectives of regulatory supervision. Federal bank regulatory agencies in the United States-the Federal Reserve System (FRS), which supervises state-chartered banks that are members of the FRS and all bank holding companies; the Federal Deposit Insurance Corporation (FDIC), which supervises state-chartered banks that are not members of the FRS; and the Office of the Comptroller of the Currency (OCC), which supervises federally chartered or national banks-have a broad range of enforcement powers over the institutions they supervise as well as the officers, directors, and employees associated with these supervised institutions. …

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