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Sanctioning banks controls their risk

Study shows stricter supervision, not new laws alone, is the most effective way of curbing risk

Stricter supervision of banks, and not the mere adoption of new laws and policies, is the most effective way of restraining risk in the banking system and preventing another financial crisis, a new study suggests.

Research has revealed that banks in countries where financial regulators conduct regular audits and frequently impose disciplinary sanctions run fewer risks than those in countries where public sanctions are less common.

The study, by Cass Business School and the University of Piraeus, in Greece, examined the individual impact of supervision (monitoring and enforcement) and regulation (law-on-the-books) on curbing bank risk, as well as their combined effectiveness.

The research, published in the highly-respected Review of Finance, found that countries which inspect banks more regularly and adopt a more forceful attitude had greater success in restraining risk.

Intriguingly, they also discovered that simply passing laws requiring specific behaviour failed to curb risk unless it was combined with effective audits and enforcement action.

Co-author of the study, Dr Manthos Delis from Cass Business School, said the study holds important lessons for regulators seeking to prevent the next financial crisis. "Our findings suggest that regulators should place more emphasis on auditing, and where needed, sanctioning banks for faulty behaviour, than on formal rules and regulations," he said.

"If anything, the new regulatory umbrella should be more focused, not on further raising capital requirements, but on enhancing the transparency in the banking system."

He added: "All in all, it appears that effective, regular and timely audits and enforcement action rather than the mere adoption of regulation holds the key in deterring excessive bank risk."

The authors also discovered that capital regulation, either directly or through its effective supervision, did not curtail bank risk, except at those banks that held a level of capital very close to the minimum. "A credible threat of supervisory intervention appears to be the underlying driving force behind the disciplinary effect of capital requirements, and not the levels of capital itself," explained Dr Delis.

"It appears that regulatory persistence with capital adequacy constraints is rather unwarranted and that the policy making agenda should instead be re-orientated towards the effective implementation of disclosure requirements."

This is an open research agenda for Dr Delis. Indeed one wants to consider whether besides their effect on risk, sanctions have some effects on banks that could be adverse. Most notably, a sanctioned bank is likely to see a drop in its market value and a deterioration in its ability to borrow funds and raise capital. In this respect imposing a sanction could imply a trade-off between the resulting banking stability and increased turmoil, especially if the involved bank is systemically important.

The study was conducted using databases of regulatory activity in each country which the authors compared with the level of risk in the banking system.

By looking at regulatory staffing levels as well as the frequency of inspections, audits and enforcement activity in 17 countries from 1998 to 2008, academics were able to assess the amount of risk being run by the banking system.

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