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There are some pieces of research that only central banks can do. For example, Jae Hyun Jo, Stefano Demartis and Spyros Palligkinis of the ECB have access to confidential information about bank supervision actions. And this means they’ve been able to look at a question that might have quite broad implications: how much of a difference does it make when bank supervisors get really up close and personal?
The answer appears to be “potentially quite a lot”.
The ECB team studied the period shortly after the COVID pandemic, when supervisors were particularly interested in the future of commercial real estate lending. They carried out two types of exercise to monitor and improve practices in the European CRE market — “targeted reviews” and “on-site inspections”.
The difference between the two is easy to work out from the names. A targeted review is targeted at a range of banks where the supervisors think there might be some reason for concern. While an on-site inspection is a more intrusive and labour-intensive process, involving a team that has to visit specific banks’ offices and review things face to face.
Obviously, the two things aren’t directly comparable. Because the ECB bank supervisors have limited resources, they are likely to concentrate the on-site inspections on banks where they really think that there is a problem and leave the cases where there might be a problem for desk-based targeted reviews. But if you have enough data about other risk characteristics and inspection results, you can begin to control for this. And then you can ask the question as to which method gets the better results.
The ECB economists chose to look at the “coverage ratio” as their outcome measure. This is the ratio of bad debt provisions to the CRE loan book. (When the numbers have been suitably massaged and standardised to take into account differences in underlying quality) it’s a good measure of conservatism. Banks with slightly sketchy risk management functions tend to under-reserve, as they have fooled themselves that bad loans are good, or that their collateral is worth more than it really is.
On this basis, it seems that an on-site inspection has an immediate and permanent effect (high def):
Targeted reviews, however . . . (high def):
To reiterate, this analysis is meant to take into account the fact that the samples of banks are different, that the loans are different and that the starting positions of the coverage ratios are different. It’s purely the effect of going into the offices and looking the bankers in the eye.
It doesn’t mean to say that targeted reviews are useless. As the ECB team points out, a targeted review improves things significantly for as much as a year. They are also considerably cheaper and more practical to apply to a wide cross-section of the industry, and this is not nothing.
But it does demonstrate that if you want to change behaviour, there’s nothing like the personal touch.
