The Role of Supervisory Screens and Econometric Models in Off-Site Surveillance

See White (1991) for a discussion of the role of lax government supervision in the thrift debacle of the 1980s. B anking is one of the more closely supervised industries in the United States, reflecting the view that bank failures have stronger adverse effects on economic activity than other business failures. Bank failures can disrupt the flow of credit to local communities (Gilbert and Kochin, 1989), interfere with the operation of the payments system (Gilbert and Dwyer, 1989), and reduce the money supply (Friedman and Schwartz, 1963). Bank failures also can have lingering effects on the real economy. Indeed, a growing body of literature blames the length of the Great Depression on the disruption of credit relationships that followed the wave of bank failures during the early 1930s The existence of unfairly priced deposit insurance bolsters the case for bank supervision. Without insurance, depositors have strong incentives to monitor and discipline risky institutions by withdrawing funds or demanding higher interest rates. Insured depositors, in contrast , have little incentive to monitor and discipline risk (Flannery, 1982). Moreover, deposit insurance premiums established under the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) do not appear to punish risk adequately. The spread between the premiums paid by the riskiest and safest banks is only 27 basis points, and just 562 of the 10,486 FDIC-insured institutions paid any premiums during the first half of 1999 (Barancik, 1999). As a result, bank supervisors must act as agents of the taxpayers to limit risk. Supervisory limits on bank risk reduce the likelihood that failures will exhaust the deposit insurance fund and impose direct costs on the taxpayers. 1 Bank supervisors use on-site examination and off-site surveillance to identify banks likely to fail. Supervisors then can take steps to reduce the likelihood that these institutions will fail. The most useful tool for identifying problem institutions is on-site examination, in which examiners travel to a bank and review all aspects of its safety and soundness. On-site examination is, however, both costly and burdensome: costly to supervisors because of its labor-intensive nature and burdensome to bankers because of the intrusion into day-today operations. As a result, supervisors also monitor bank condition off-site. Off-site surveillance yields an ongoing picture of bank condition, enabling supervisors to schedule and plan exams efficiently. Off-site surveillance also provides banks with incentives to maintain safety and soundness between on-site visits. In off-site surveillance, …