Researchers at the Federal Reserve Bank of New York and Others: Stricter Regulation May Lower Bank Resolution Costs but Could Tighten Credit Supply
Researchers from the Federal Reserve Bank of New York, the Federal Reserve Bank of Richmond, and MIT Sloan School of Management used U.S. commercial bank regulatory data from 2000 to 2023 to find that bank failures typically stem from supervisory closure decisions based on book capital, which is itself partly shaped by supervisory examinations—examinations that force banks to recognize previously hidden losses. This 'supervision creates information, information triggers closure' cycle implies that stricter regulation can reduce resolution costs, but potentially at the expense of tighter credit supply, especially when credit conditions are already weak.
Since 2000, a total of 557 commercial banks in the United States have failed, with only 28 of them closing on any day other than Friday. Friday is the preferred closure day for the Federal Deposit Insurance Corporation (FDIC), and acquirers are typically arranged before the failure occurs. This means that modern bank failures are rarely triggered by market forces such as deposit runs, but instead follow supervisory closure decisions. For comparison, between 1865 and 1935, before the establishment of the federal deposit insurance system, bank failure dates were distributed almost uniformly across the days of the week—the researchers believe that at that time, depositors and shareholders usually determined the timing of the closure themselves.
But there is an easily overlooked feedback loop here: the basis for supervisors to close banks is book capital (the CET1 ratio), and book capital itself is partly produced by supervisory examinations. The researchers found that the probability of a bank revising its previously submitted financial statements (call reports) sharply increases around on-site supervisory examinations; over the five years preceding a bank's failure, its equity-to-assets ratio typically declines by 8 percentage points, nearly 3 of which come from revisions triggered by examination-induced loss recognition. In other words, supervisors force banks to write potential losses into their statements through examinations, and then use those worsened figures to decide on closure. In the CAMELS rating system, the capital sub-component is mechanically related to book capital, while the management sub-component allows for supervisory discretion—for well-capitalized banks, the composite rating is closer to the management rating; for severely undercapitalized banks, the composite rating is almost equivalent to the capital rating.