The financial crisis that the U.S. is currently experiencing has resulted in proposals for tighter regulation of financial institutions. But implementing new regulatory reforms should be done after a careful analysis of its consequences on the financial system, and more specifically, on banking behavior. Undoubtedly, banking regulation and prudential supervision exists because it is thought to promote an efficient and competitive banking system. It is also thought to help prevent the occurrence of large and sustained financial disruptions caused by banking panics and failures, and, in addition, to reduce depositor’s risk exposure to episodes of financial distress.
While these objectives serve to ensure the stability and growth of the macroeconomy, they may not be costless to the banking sector. Indeed, many studies of bank regulation focus on the identification and estimation of these costs. The concern stems from the possibility that regulatory oversight can unintentionally impose costs that may be unduly burdensome, thereby becoming financial straightjackets for bank lending operations.
The purpose of this paper is to study in greater detail how bank supervision, through its evaluation process, affects bank-lending operations. Regulatory oversight requires that all federally insured commercial banks be periodically evaluated through on-site examinations as well as off-site monitoring. The evaluation results in the assignment of a “CAMEL” safety and soundness rating based on the overall financial health of the institution.
A downgrade in this rating conveys the message that the bank’s financial health has deteriorated, and that its management must take corrective action to improve its supervisory rating. It is, therefore, not far-fetched to think that “CAMEL” ratings downgrades, especially those to the 3, 4 or 5 level, would be associated with more conservative or restricted lending practices and potentially higher capital requirements at least in the short run. Thus, a poor rating has real consequences for how the bank operates.