Is there a regulatory trade-off between stability and performance?

Disentangling the direct causal effect that sanctions exert on bank performance from the indirect through default risk, we show that a trade-off exists for regulators between banks’ performance and stability in Italy. Two key findings provide evidence for the nontriviality of the return-risk nexus: (i) banks’ liquidations are concentrated at the lower-end of the profitability distribution, resulting in (attrition) biased estimates; (ii) the drop-out is informative since it depends on the unobserved measurements of profitability. Despite this evidence, while returns are affected by sanctions and regulatory requirements, default risk is not. However, looking at growth of gross loans, enforcement actions reduce default risk though at a cost of a significant fall in lending, creating a regulatory tradeoff. In fact, through loans’ growth, we account for the key dynamics of intermediaries’ soundness, namely higher profits and less non-performing loans.