Contrary to the common belief that financial supervision is costly for bank shareholders, agency theory indicates that supervisors’ audits can actually save shareholders money. Emilio Bisetti of HKUST examines this apparent contradiction in a unique setting—a sudden and unexpected decrease in off-site surveillance by the U.S. Federal Reserve (the Fed).

“A widely held view in the banking industry is that reporting to supervisory authorities has a negative impact on shareholder value,” notes the researcher. Yet agency theory offers a different perspective. “By auditing banks’ information,” explains Bisetti, “supervisors may align the incentives of bank shareholders and regulators, lift the burden of verification from shareholders, and increase bank value.”

To shed light on whether supervisory audits can benefit shareholders by reducing their private audit costs, the author exploits the Fed’s relaxation of the reporting requirements of small U.S. bank holding companies. “I show that this change in reporting leads to large losses in the market value of affected banks,” he reports.

These losses are due to both earnings management and increased expenditure on internal control systems and private audits. Furthermore, in Bisetti’s words, “the baseline treatment effect is economically larger in treated banks whose cash flows are more opaque and difficult to evaluate by supervisors and market participants.”

These results have two main policy implications. First, while regulators are shifting toward off-site supervisory technology (SupTech) over traditional on-site inspections, the findings suggest that these tools serve different purposes, and that SupTech alone may fall short in curbing bank risk-taking.

“Additionally,” says the author, “my results speak to a heated policy discussion on the costs and benefits of paperwork reduction policies for small and medium-sized banks in the United States.” Such reforms may not only fail to reduce the regulatory burden but also incur private costs for bank shareholders.