U.S. prompt corrective action and bank risk

This paper examines whether Prompt Corrective Action (PCA) was effective in reducing default and credit risk in U.S. banking. We employ parametric, non-parametric, nonlinear and switching cointegration tests and a general-to-specific testing procedure to examine if PCA-defined bank ratios and risk measures share common stochastic trends. We find strong evidence of switching cointegration between PCA-defined ratios and default risk. This occurs in 1993 and coincides with the adoption of PCA legislation. We conclude that PCA is effective in reducing default risk. In contrast, there is no clear evidence of cointegration between the PCA-defined ratios and credit risk. Our findings show that tougher capital standards mitigate default risk and therefore provide indirect support for current on-going capital regulation.