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Noisy Experts? Discretion in Regulation

Author

Listed:
  • Sumit Agarwal
  • Bernardo C. Morais
  • Amit Seru
  • Kelly Shue
Abstract
While reliance on human discretion is a pervasive feature of institutional design, human discretion can also introduce costly noise (Kahneman, Sibony, and Sunstein 2021). We evaluate the consequences, determinants, and trade-offs associated with discretion in high-stake decisions assessing bank safety and soundness. Using detailed data on the supervisory ratings of US banks, we find that professional bank examiners exercise significant personal discretion—their decisions deviate substantially from algorithmic benchmarks and can be predicted by examiner identities, holding bank fundamentals constant. Examiner discretion has a large and persistent causal impact on future bank capitalization and supply of credit, leading to volatility and uncertainty in bank outcomes, and a conservative anticipatory response by banks. We identify a novel source of noise: weights assigned to specific issues. Disagreement in ratings across examiners can be attributed to high average weight (50%) assigned to subjective assessment of banks’ management quality, as well as heterogeneity in weights attached to more objective issues such as capital adequacy. Replacing human discretion with a simple algorithm leads to worse predictions of bank health, while moderate limits on discretion can translate to more informative and less noisy predictions.

Suggested Citation

  • Sumit Agarwal & Bernardo C. Morais & Amit Seru & Kelly Shue, 2024. "Noisy Experts? Discretion in Regulation," NBER Working Papers 32344, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:32344
    Note: CF ME
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    JEL classification:

    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G4 - Financial Economics - - Behavioral Finance

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