This paper investigates the role of banking supervision in controlling bank risk. Banking supervision is measured in terms of enforcement outputs (i.e., on-site audits and sanctions). Our results show an inverted U-shaped relationship between on-site audits and bank risk, while the relationship between sanctions and risk appears to be linear and negative. We also consider the combined effect of effective supervision and banking regulation (in the form of capital and market discipline requirements) on bank risk. We find that effective supervision and market discipline requirements are important and complementary mechanisms in reducing bank fragility. This is in contrast to capital requirements, which prove to be rather futile in controlling bank risk, even when supplemented with a higher volume of on-site audits and sanctions.

We study whether formal enforcement actions, imposed on U.S. banks during 2000–2014 for serious financial safety and internal control problems, affect the probability that punished banks become targets of mergers and acquisitions (M&As). We find an increase in the probability of punished banks' acquisitions of at least 0.7%. A similar pattern is identified during both the financial crisis period of 2008–2009 and beyond the 2008–2009 period. Furthermore, these acquisitions improve the operating performance of post-acquisition combined entity, lending support to the hypothesis that punished banks' M&As serve as a means to replace inefficient management and restore the target banks' performance.

We assess the effect of formal enforcement actions against banks for safety and soundness reasons on punished banks’ deposits, and then examine whether this effect is caused by demand-side or supply-side forces. To this end, we use hand-collected data on enforcement actions, and bank-quarter data on deposits and other bank characteristics from 2000 through 2014. Our results show that total deposits at punished banks decrease by 8.5% in the post-enforcement year, with uninsured deposits declining by 14.5% and insured deposits falling by 7.4%. We also find that the deposit decline is predominantly caused by demand-side forces, that is, by punished banks’ decision to curtail the asset side of their balance sheet.