How prompt was regulatory corrective action during the financial crisis?

•Investigate the incidence of regulatory forbearance during the financial crisis.•Failed banks consistently underreported loan impairment during crisis.•Impairment-adjusted capital ratios show forbearance up to 18 months prior to seizure.•Bank coverage ratios negatively and significantly related to impairment.•Bank coverage ratios significantly lower for banks with critically low capital.

This paper empirically investigates the incidence of regulatory forbearance during the financial crisis. Using an option pricing technique in concert with valuation data gathered from failed bank sales, I find that failed banks consistently underreported the level of impairment in loan portfolios during the financial crisis period of 2008–2010, helping these market value insolvent banks to report adequate capital for regulatory purposes. Impairment-adjusted capital ratios provide evidence of regulatory forbearance for up to 18 months prior to seizure. Analyses of bank coverage ratios reveal that coverage ratios are negatively and significantly related to impairment levels and are significantly lower for banks with critically low levels of capital.