Impact of FDICIA internal controls on bank risk taking

The Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 was designed, among other things, to introduce risk-based deposit insurance, increase capital requirements, and improve banks’ internal controls. Of particular interest in this study are the requirements for annual audit and reporting of management’s and auditor’s assessment of the effectiveness of internal control for banks with $500 million or more in total assets (raised to $1 billion in 2005). We study the impact of these requirements on banks’ risk-taking behavior prior to the recent financial crisis and the consequent implications for bank failure and financial trouble during the crisis period. Using a sample of 1138 banks, we provide evidence that banks required to comply with the FDICIA internal control requirements have lower risk taking in the pre-crisis period. Specifically, the volatility of net interest margin, the volatility of earnings, and Z score show less risk-taking behavior. Furthermore, these banks are less likely to experience failure and financial trouble during the crisis period.     

Ability of accounting and audit quality variables to predict bank failure during the financial crisis

We examine the ability of selected accounting and audit quality variables measured in a period prior to the financial crisis (i.e., the four quarters of 2006), to predict banks that subsequently failed during the financial crisis. We employ two sets of samples from the US: a troubled banks sample that includes banks that failed in or after 2007 as well as banks classified as being troubled based on profitability, loan quality, and balance sheet position in 2007, and a full sample that includes all banks with available required data. Using the troubled banks sample, we identify six reliable predictors of bank failure: auditor type, auditor industry specialization, Tier 1 capital ratio, proportion of securitized loans, growth in loans, and loan mix. For the larger full sample of banks, we identify the following ten predictors of bank failure: auditor type, Tier 1 capital ratio, proportion of securitized loans, nonperforming loans, loan loss provisions, growth in commercial loans, growth in real estate loans, growth in overall loans, loan mix, and whether the bank is a public bank.     

Auditor reputation and earnings management: International evidence from the banking industry

We examine the relation between auditor reputation and earnings management in banks using a sample of banks from 29 countries. In particular, we examine the implications of two aspects of auditor reputation, auditor type and auditor industry specialization, for earnings management in banks. We find that both auditor type and auditor industry specialization moderate benchmark-beating (loss-avoidance and just-meeting-or-beating prior year’s earnings) behavior in banks. In addition, we find that once auditor type and auditor industry specialization are included in the same tests, only auditor industry specialization has a significant impact on constraining benchmark-beating behavior. In separate tests related to income-increasing abnormal loan loss provisions, we find that both auditor type and auditor expertise constrain income-increasing earnings management. Again, in joint tests, only auditor industry expertise has a significant impact on constraining income-increasing earnings management.     

Determinants of auditor changes for non-accelerated filers

Significant accounting scandals and the imminent collapse of Arthur Andersen in 2001 precipitated a period of heightened regulatory response, most notably the enactment of the Sarbanes–Oxley Act of 2002. In the years that followed, the Securities and Exchange Commission created a separate class of non-accelerated filers (companies with public float of up to $75 million) and provided these companies with significant regulatory relief from certain financial reporting disclosure and auditing requirements, including the extension of scaled disclosure to these companies in 2007. Over the period of 2001 through 2007, as non-accelerated clients anticipated and responded to their different and evolving regulatory regime, audit firms were adjusting to the increased concentration in their market, a new monitoring structure, and significant changes to the scope of their work. We examine whether auditor–client misalignment is a significant determinant of auditor change during this period, particularly for non-accelerated filers, as large auditors sought to rebalance their client portfolios. We find evidence that auditor–client misalignment increases the likelihood of auditor change (resignation and dismissal) for non-accelerated, but not accelerated, filers. We also find that auditor–client misalignment increases the likelihood of downward changes to third-tier auditors for non-accelerated, but not accelerated, filers.     

Efficiency,technical change,and returns to scale in large US banks: Panel data evidence from an output distance function satisfying theoretical regularity

This paper provides parametric estimates of technical change, efficiency change, economies of scale, and total factor productivity growth for large banks (those with assets in excess of $1 billion) in the United States, over the period from 2000 to 2005. This is done by estimating an output distance function subject to theoretical regularity within a Bayesian framework. We find that failure to incorporate theoretical regularity conditions results in mismeasured shadow revenue and/or cost shares, which in turn leads to perverse conclusions regarding productivity growth. Our results from the regularity-constrained model show that total factor productivity of the large US banks grew at an average rate of 1.98% over the sample period. However, our estimates also show a clear downward trend in the growth rate of total factor productivity and our decomposition of the primal Divisia total factor productivity growth index into its three components – technical change, efficiency change, and economies of scale – indicates that technical change is the driving force behind this decline.     

Is the market valuation of banks’ loan loss provision conditional on auditor reputation?

We examine how auditor reputation conditions the market valuation of banks’ loan loss provision (LLP). The inherent uncertainty associated with and discretion permitted in estimating the LLP contributes to information asymmetry. The auditor’s certification and monitoring roles influence firm value by mitigating this information asymmetry. We examine two aspects of auditor reputation, auditor type (Big 5 vs. non-Big 5) and auditor expertise, in the banking industry. We find a significant, positive association between the discretionary component of LLP and stock return for banks audited by the Big 5 auditors. Further analysis indicates that auditor expertise within banking and not auditor type drives this significant, positive association. Overall, our results are consistent with auditor expertise in the banking industry mitigating information asymmetry between bank managers and investors and enhancing the information conveyed by discretionary loan loss provision.     

Stress testing credit risk: The Great Depression scenario

By employing Moody’s corporate default and rating transition data spanning the last 90 years we explore how much capital banks should hold against their corporate loan portfolios to withstand historical stress scenarios. Specifically, we will focus on the worst case scenario over the observation period, the Great Depression. We find that migration risk and the length of the investment horizon are critical factors when determining bank capital needs in a crisis. We show that capital may need to rise more than three times when the horizon is increased from 1 year, as required by current and future regulation, to 3 years. Increases are still important but of a lower magnitude when migration risk is introduced in the analysis. Further, we find that the new bank capital requirements under the so-called Basel 3 agreement would enable banks to absorb Great Depression-style losses. But, such losses would dent regulatory capital considerably and far beyond the capital buffers that have been proposed to ensure that banks survive crisis periods without government support.     

The Real Effects of FAS 166/167 on Banks’ Mortgage Approval and Sale Decisions

We examine the real effects of FAS 166 and FAS 167 on banks’ loan‐level mortgage approval and sale decisions. Effective in 2010, these standards tightened the accounting for securitizations and consolidation of securitization entities, respectively, causing banks to recognize an estimated $811 billion of securitized assets on balance sheet. We find that banks that recognize more securitized assets exhibit larger decreases in mortgage approval rates and larger increases in mortgage sale rates. These effects significantly exceed those of banks’ off–balance sheet securitized assets, consistent with our results being driven by the consolidation of securitization entities rather than by securitization per se. We conduct tests that help rule out the financial crisis as an alternative explanation for our results. Further analyses suggest that mechanisms underlying the results include consolidating banks’ reduced regulatory capital adequacy, increased market discipline, and consequent desire not to recognize high‐risk mortgages on balance sheet.     

Market discipline, financial crisis and regulatory changes: Evidence from Indonesian banks

Following the 1997/1998 financial crisis, Indonesian banks experienced major regulatory changes, including the adoption of the blanket guarantee scheme (BGS) in 1998, a limited guarantee (LG) in 2005, and changes in capital regulation in 1998 and 2001. We examine the impact of these regulatory changes on market discipline during the period 1995-2009. The price of deposits is used to measure market discipline in a dynamic panel data methodology on a sample of 104 commercial banks. We find a weakening of market discipline following the introduction of the BGS. The result is consistent with the deposit insurance scheme being credible in the lower capital requirement environment. The adoption of LG in a recovering economy also mitigates the role of market discipline. However, market discipline is more pronounced in listed banks than unlisted banks and in foreign banks than domestic banks. These results have important implications for banking regulation and supervision, particularly during a crisis period.     

Global retail lending in the aftermath of the US financial crisis: Distinguishing between supply and demand effects

This paper examines the broader effects of the US financial crisis on global lending to retail customers. In particular we examine retail bank lending in Germany using a unique data set of German savings banks during the period 2006 through 2008 for which we have the universe of loan applications and loans granted. Our experimental setting allows us to distinguish between savings banks affected by the US financial crisis through their holdings in Landesbanken with substantial subprime exposure and unaffected savings banks. The data enable us to distinguish between demand and supply side effects of bank lending and find that the US financial crisis induced a contraction in the supply of retail lending in Germany. While demand for loans goes down, it is not substantially different for the affected and nonaffected banks. More important, we find evidence of a significant supply side effect in that the affected banks reject substantially more loan applications than nonaffected banks. This result is particularly strong for smaller and more liquidity-constrained banks as well as for mortgage as compared with consumer loans. We also find that bank-depositor relationships help mitigate these supply side effects.     

Nonlinear incentives and mortgage officers’ decisions

In the aftermath of the recent financial crisis, banks should ensure that their incentive compensation policies appropriately balance long-term risk with short-term rewards. Using daily output data from mortgage officers in a US commercial bank, we test the notion that nonlinear contracts create time-varying incentives for the employees and impose costs on the firm. We provide empirical evidence that mortgage officers greatly increase their output toward the end of each month, when the minimum monthly quota is assessed. This occurs through a combination of reducing the processing time and approving some marginal applications. We also find that mortgages originated on the last working day of the month have a higher likelihood of delinquency.     

Disclosures of material weaknesses by Japanese firms after the passage of the 2006 Financial Instruments and Exchange Law

We investigate the disclosures of material weaknesses in internal control mandated for Japanese firms under the 2006 Financial Instruments and Exchange Law. We find that the presence of a material weakness is more likely for firms that are younger, have better growth prospects, have a volatile operating environment, are financially constrained, and have weak governance structures. We examine the role of Japan’s main banks in this process and find that the likelihood of a material weakness is higher for firms with stronger links with their main banks. We also show that the financial health of the main banks themselves—proxied for by the banks’ BIS ratios and bad loan ratios—increases the likelihood of a material weakness in affiliated firms. This paper provides novel insights into the determinants of material weaknesses of Japanese firms since the passage of the law. Results from this study contribute to the literature on material weaknesses and relationship banking.     

The American keiretsu and universal banks: Investing,voting and sitting on nonfinancials’ corporate boards

This paper investigates the equity investments and voting rights that American banks control through their trust business. The paper also studies whether the voting rights American banks control through their trust business help explain their presence on firms’ corporate boards. We find that on average the largest 100 American banks control 10% of the voting rights of S&P 500 firms. We also find that there are several firms in the S&P 500 index in which the top banks control more than 20% of their voting rights, and several firms in the country in which these banks control more than 60% of their voting rights. Our investigation into the presence of American bankers on corporate boards shows that bankers are more likely to join the boards of firms in which they control a large voting stake. We also find that banks’ lending relationships help explain bankers’ board memberships. Our results further show that bankers who have both a voting stake in a firm and a lending relationship with it have a higher likelihood of joining the firm's board of directors.     

Asset management and investment banking

We find evidence that conflicts of interest are pervasive in the asset management business owned by investment banks. Using data from 1990 to 2008, we compare the alphas of mutual funds, hedge funds, and institutional funds operated by investment banks and non-bank conglomerates. We find that, while no difference exists in performance by fund type, being owned by an investment bank reduces alphas by 46 basis points per year in our baseline model. Making lead loans increases alphas, but the dispersion of fees across portfolios decreases alphas. The economic loss is $4.9 billion per year.     

Creditor rights,information sharing,and bank risk taking

Looking at a sample of nearly 2,400 banks in 69 countries, we find that stronger creditor rights tend to promote greater bank risk taking. Consistent with this finding, we also show that stronger creditor rights increase the likelihood of financial crisis. On the plus side, we find that stronger creditor rights are associated with higher growth. In contrast, we find that the benefits of information sharing among creditors appear to be universally positive. Greater information sharing leads to higher bank profitability, lower bank risk, a reduced likelihood of financial crisis, and higher economic growth.     

The Use of Interest Rate Derivatives by End-users: The Case of Large Community Banks

This paper investigates the use of interest-rate derivatives by U.S. commercial banks with total assets between $100 million and $1 billion. These banks are interesting, because they allow us to focus on the end-users of interest-rate derivatives rather than dealers. Over our four-year test period, 1990–1993, only 10% of these large community banks, on average about 250 banks per year, used any interest-rate derivatives. We find evidence that the use of interest-rate derivatives is positively related to exposure to interest-rate risk as measured by the absolute value of the 12-month maturity gap. In addition, a community bank's decision to participate in interest-rate contracts is positively related to size. Nevertheless, we find no positive relationship between size and the extent of participation in the derivatives market. Finally, our evidence suggests that banks that participate more heavily in interest-rate swaps have stronger capital positions, an indicator of market or regulatory discipline or both.     

Institutional investor inattention and audit quality

We hypothesize and provide empirical evidence that higher institutional investor inattention is associated with lower audit quality. We employ an inattention measure that captures the extent to which institutional investors are distracted by attention-grabbing events irrelevant to the focal firm. Results suggest that a higher degree of institutional investor inattention is associated with a lower propensity of a going-concern opinion, a lower probability of the auditor reporting a material internal control weakness, and a higher likelihood of the audit client misstating the financial statements. Further analyses show that these associations vary by auditor litigation risk, their workload pressure, auditor industry expertise, and analyst coverage. Overall, our findings reveal that while institutional investors play an important monitoring role, the distractions they face undermine the quality of monitoring they provide.     

TARP funds distribution and bank loan supply

This paper investigates the determinants of the Troubled Asset Relief Program (TARP) funds distribution to banks and the stimulus effect of TARP investments on credit supply in the economy. Using banks’ political and regulatory connections as instruments, this paper finds that TARP investments increased bank loan supply by an annualized rate of 6.36% for banks with below median Tier 1 capital ratios. This increase is found in all major types of loans and can be translated into $404 billion of additional loans for all TARP banks. On average, TARP banks employed about one-third of their TARP capital to support new loans and kept the rest to strengthen their balance sheets. Furthermore, there is little evidence that loans made by TARP banks had lower quality than those by non-TARP banks. In sum, this paper shows a positive stimulus effect of TARP on credit supply during the 2008–2009 financial crisis.     

Do bank regulation,supervision and monitoring enhance or impede bank efficiency?

The recent global financial crisis has spurred renewed interest in identifying those reforms in bank regulation that would work best to promote bank development, performance and stability. Building upon three recent world-wide surveys on bank regulation (,  and ), we contribute to this assessment by examining whether bank regulation, supervision and monitoring enhance or impede bank operating efficiency. Based on an un-balanced panel analysis of 4050 banks observations in 72 countries over the period 1999–2007, we find that tighter restrictions on bank activities are negatively associated with bank efficiency, while greater capital regulation stringency is marginally and positively associated with bank efficiency. We also find that a strengthening of official supervisory power is positively associated with bank efficiency only in countries with independent supervisory authorities. Moreover, independence coupled with a more experienced supervisory authority tends to enhance bank efficiency. Finally, market-based monitoring of banks in terms of more financial transparency is positively associated with bank efficiency.