Assessing Regulatory Responses to Troubled Banks

How can the public assess the performance of regulators who administer the resolution of troubled banks? Economic theory indicates that regulators best serve the public interest when they act to discourage moral hazard and preserve channels of financial intermediation. I study the resolution of failed financial institutions in the US over the period 1984-1992, characterized by concurrent crises in the banking and Savings and Loans(S&L) industries. I determine whether regulators in the two industries conformed to norms of optimal resolution by developing a Bayesian estimation algorithm to uncover their decision rules. The results show that the banking regulator provided assistance and carried out liquidations with higher probability when failures occurred amid adverse and benign local economic conditions respectively. Whereas the former's actions align with theoretical recommendations, the S&L regulator did not distinguish across failures based on underlying economic characteristics. These findings provide insights into the differences in responses that contributed to the resilience of the banking regulator through the crisis and the eventual insolvency of the S&L regulator. The estimation approach developed here addresses unobserved heterogeneity, allows straightforward inference on quantities of interest and offers a coherent framework for model comparison