Information Frictions in Uncertain Regulatory Environments: Evidence from U.S. Commercial Banks
| Published date | 01 April 2017 |
| Author | Stan Veuger,Kristin Wilson |
| DOI | http://doi.org/10.1111/obes.12143 |
| Date | 01 April 2017 |
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©2016 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd.
OXFORD BULLETIN OF ECONOMICSAND STATISTICS, 79, 2 (2017) 0305–9049
doi: 10.1111/obes.12143
Information Frictions in Uncertain Regulatory
Environments: Evidence from U.S. Commercial
Banks*
Kristin Wilson† and Stan Veuger‡
†Kenan-Flagler Business School, University of North Carolina at Chapel Hill, Campus Box
3490, McColl 4612, Chapel Hill, NC 27599-3490, USA (e-mail: kristin wilson@unc.edu)
‡American Enterprise Institute, Economic Policy Studies, 1150 17th Street NW, Washington,
DC 20037, USA (e-mail: stan.veuger@aei.org)
Abstract
Information frictions between firms and regulators are typically seen as a means by which
firms evade enforcement. In contrast, weargue that information frictions between firms and
regulators can reduce the efficiency of firms’ compliance efforts when the interpretation
of regulatory standards is uncertain. We exploit plausibly exogenous variation in distance
between firms and their regulators to demonstrate this for a panel of community banks in
the US. We find that banks located at greater distance from regulatory field offices face
significantly higher administrative costs, at a rate of 20% of administrative costs per hour
of travel time. These differences do not come with reduced compliance, are not driven by
endogenous regulator choice, and are stable over time. Further, the costs borne by distant
firms are negatively related to the scale of the jurisdiction in whichthey operate, suggesting
that information spillovers between firms limit uncertainty about regulatory expectations.
I. Introduction
Regulatory oversight demands ongoing, two-way information exchange between firms and
regulators. Firms must determine what actions are expected of them, and regulators must
determine if firms follow through on these actions. Studies of the information exchange
between firms and regulators have generally focused on problems associated with the
latter, exploring, under various enforcement mechanisms, firms’ incentives to exploit their
information advantage overtheir regulator (Becker, 1968; Laffont and Tirole, 1993). Under
JEL Classification numbers: D8; G21; G28; K2; L5
*Wethank Jeffrey Clemens, Jeffry Frieden, Guido Imbens, Jeffrey Liebman, JeffreyMiron, Felix Oberholzer-Gee,
Dennis Yao, Jordan Siegel, Scott Rockart and Michael Strain, as well as seminar attendees at the Federal Reserve
Board of Governors, the Harvard Department of Government, Harvard Business School, the Institute for Humane
Studies, MIT, and the 11th Strategy and the Business EnvironmentConference for their helpful comments and advice.
206 Bulletin
this view of regulatory relationships, information frictions between firms and regulators
allow firms to avoid regulatory scrutiny and to reduce compliance efforts.
Anticipating regulatory expectations, however, is not trivialin practice. Several features
of the regulatory environment are likely to inhibit firms’ ability to determine what actions
are expected of them. Uncertainty about regulatory expectations starts with legal standards
that are open to interpretation (Kaplow, 1992). Ambiguous legal standards lead to admin-
istrative rules that are state-dependent, complex or qualitative. Such rules often require
delegation of enforcement discretion to individual agents (Lipsky, 2010; Macher, Mayo
and Nickerson, 2011). Uncertainty surrounding regulatory behaviour in settings where reg-
ulatory agents exercise significant discretion can be further exacerbated by bureaucratic
complexity,changing environmental conditions, and a lack of transparency in the oversight
process, all of which make it difficult for a firm to determine how an individual agent will
interpret the law at any given point in time.
Uncertainty in the interpretation of industry rules is likely to be costly for firms. Com-
pliance requires specific investments in internal control systems, planning, reporting, and
other administrative effort. When regulatory expectations are ambiguous, these actions in
anticipation of regulatory decision-making are likely to be less effective, and may lead
firms to invest in outside expertise through lawyers, consultants and former government
employees. While under particular enforcement parameters firms may respond to such un-
certainty by reducing investments in compliance, in manysettings the governments’ ability
to enforce arbitrarily high penalties makes it plausible that firms bear the costs of informa-
tion asymmetries rather than the public (Craswell and Calfee, 1986). For example, Lyon
and Mayo (2005) provide strong evidence of the ability of regulators to use large penalties
to enforce the regulatory regime in the electric utility industry. Instances, where regulators
are relatively powerful and legal standards are ambiguous are not rare, and are likely to
disproportionately affect small firms (Dolar and Shughart, 2011). Regulators may exercise
discretion over application processes, permissible investments, production requirements,
and quality standards. In the US, such discretionary oversight, by federal agencies and
local governments, touches practically all businesses in the economy, from the oversight
of multi-million-dollar drug trials to the approval of local construction projects.
In short, the regulatory framework does not always provide firms with the informa-
tion necessary to guide costly compliance efforts, and ongoing information exchange with
decision-makers may be the only means by which firms improve their understanding of
regulatory expectations at a given point in time. If this is true, the consequences of infor-
mation frictions in the enforcement relationship may be starkly different from scenarios in
which firms make a calculated bet to avoid scrutiny; rather than reduce compliance efforts,
information frictions may simply make compliance efforts more costly for firms. These
opposing predictions regarding the consequences of communication between firms and
regulators have important implications both for our understanding of policy design and for
the management of firms’ government relationships.
In this paper, we explore the role of information frictions in the regulatory relationship
in the U.S. banking industry, using cross-sectional heterogeneity in the cost of information
sharing with regulators to identify its impact on administrative costs at small community
banks. This setting has several benefits. First, the implementation of regulatory standards
in this setting can be both uncertain and costly. Banks’ risk management practices are
©2016 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd
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