Do financial regulators act in the public's interest? A Bayesian latent class estimation framework for assessing regulatory responses to banking crises

TL;DR

This paper introduces a Bayesian latent class estimation framework to evaluate whether financial regulators' decisions during banking crises align with theoretical resolution rules aimed at balancing financial stability and moral hazard, revealing historical deviations and potential improvements.

Contribution

The paper develops a novel Bayesian latent class framework for assessing regulator decisions against theoretical guidelines, addressing unobserved heterogeneity in regulatory responses.

Findings

U.S. banking regulators' decisions in the 1980s aligned with recommended rules.

U.S. S&L regulator deviated from recommended resolution strategies.

Timely evaluation could have prevented significant taxpayer losses.

Abstract

When banks fail amidst financial crises, the public criticizes regulators for bailing out or liquidating specific banks, especially the ones that gain attention due to their size or dominance. A comprehensive assessment of regulators, however, requires examining all their decisions, and not just specific ones, against the regulator's dual objective of preserving financial stability while discouraging moral hazard. In this article, we develop a Bayesian latent class estimation framework to assess regulators on these competing objectives and evaluate their decisions against resolution rules recommended by theoretical studies of bank behavior designed to contain moral hazard incentives. The proposed estimation framework addresses the unobserved heterogeneity underlying regulator's decisions in resolving failed banks and provides a disciplined statistical approach for inferring if they acted in the public interest. Our results reveal that during the crises of 1980's, the U.S. banking regulator's resolution decisions were consistent with recommended decision rules, while the U.S. savings and loans (S&L) regulator, which ultimately faced insolvency in 1989 at a cost of $132 billion to the taxpayer, had deviated from such recommendations. Timely interventions based on this evaluation could have redressed the S&L regulator's decision structure and prevented losses to taxpayers.