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posted on 08 January 2017

Enforcement Actions And Bank Loan Contracting

from the Kansas Fed

-- this post authored by Raluca A. Roman

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.

[click on image below to continue reading]

Source: https://www.kansascityfed.org/~/media/files/ publicat/econrev/ econrevarchive/ 2016/ 4q16roman.pdf

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