Would Stricter Regulators Prevent the Next Financial Crisis?

Weak regulation contributed to the 2007­–10 financial crisis, according to many investors and policy makers who accuse regulators of pandering to industry. But would stricter regulators have actually forced banks to report more transparently, or would they have backed off for fear of destabilizing the financial system?

Research suggests that strict regulators do improve reporting, particularly before and during a financial crisis.

University of Michigan’s Anna Costello, Chicago Booth’s João Granja, and MIT Sloan’s Joseph Weber studied commercial banks in the United States from 2001 through 2010, as well as the state and federal regulators who audit their financial reports. The researchers looked at financial restatements and homed in on accounting errors associated with banks inflating their capital reserves.

Restatements are a good reflection of accounting transparency, the researchers argue. “A regulatory restatement, even of small magnitude, signals that the regulators scrutinized the content of regulatory reports, detected material errors, and forced the bank to restate their reports and correct internal control weaknesses that generated these errors,” they write.

Costello, Granja, and Weber use an established measure of regulatory leniency that determines whether state regulators are strict or lax. In the US, many commercial banks have both federal and state regulators supervising them. The measure captures how lenient state regulators are in assigning confidential regulatory ratings relative to the benchmark ratings set by federal regulators in the same banks.

The researchers find that banks are significantly more likely to restate their financials, and report lower income, when they face a stricter state regulator. “We interpret this pattern of evidence as consistent with the idea that strict regulators are particularly concerned with detection and correction of material accounting errors that artificially increase regulatory capital,” they write.

But do strict regulators act preemptively, or do they simply crack down when there’s an apparent problem? The evidence supports the former scenario, the researchers find. “The effects of regulatory leniency become stronger and statistically significant in 2007 when the first signs of the housing crisis became apparent,” write Costello, Granja, and Weber, adding that strict regulators demanded restatements at an early stage of the crisis. “The effects of regulatory incentives are less pronounced after 2008, which is consistent with the idea that even lax regulators increased their oversight once the problems of the banking system were widely recognized.”