How banks respond to Central Bank supervision: Evidence from Brazil

• We analyze whether Central Bank supervision exerts positive pressure on bank's decision on the capital requirements.
• We use a unique dataset which provides the proprietary rating of each bank in addition to supervision actions from the Central Bank.
• We also evaluated (i) how market discipline may play a minor role in driving capital ratios; and (iii) how the business cycle has a negative impact on bank's capital cushion, suggesting a pro-cyclical capital management.

Central Bank supervision is one of the pillars of capital regulation. Based on a unique database built using supervision data from the Central Bank of Brazil, we evaluate the effectiveness of the Central Bank's supervision over banks given the Central Bank's proprietary credit rating and signaling requests for higher capital buffers. We also examine the main determinants of capital buffer management in addition to supervision. We find evidence that (i) Brazilian Central Bank supervision imposes excess capital buffer needs on banks, especially small and midsize banks; (ii) market discipline may play no role in driving capital ratios; and (iii) the business cycle has a negative influence on bank capital cushions, suggesting pro-cyclical capital management. We conclude that supervision plays a major role in markets where market discipline is weak and for smaller banks which act on pro-cyclical way.