Banks’ Financial Reporting and Financial System Stability

The use of accounting measures and disclosures in banks’ contracts and regulation suggests that the quality of banks’ financial reporting is central to the efficacy of market discipline and nonmarket mechanisms in limiting banks’ development of debt and risk overhangs in economic good times and in mitigating the adverse consequences of those overhangs for the stability of the financial system in downturns. This essay examines how research on banks’ financial reporting, informed by the financial economics literature on banking, can generate insights about how to enhance the stability of the financial system. We begin with a foundational discussion of how aspects of banks’ accounting and disclosures may affect stability. We then evaluate representative papers in the empirical literature on banks’ financial reporting and stability, pointing out the research design issues that empirical accounting researchers need to confront to develop well‐specified tests able to generate reliably interpretable findings. To this end, we provide examples of settings amenable to addressing these issues. We conclude with considerations for accounting standard setters and financial system policy makers.     

A Tale of Two Runs: Depositor Responses to Bank Solvency Risk

We examine heterogeneity in depositor responses to solvency risk using depositor‐level data for a bank that faced two different runs. We find that depositors with loans and bank staff are less likely to run than others during a low‐solvency‐risk shock, but are more likely to run during a high‐solvency‐risk shock. Uninsured depositors are also sensitive to bank solvency. In contrast, depositors with older accounts run less, and those with frequent past transactions run more, irrespective of the underlying risk. Our results show that the fragility of a bank depends on the composition of its deposit base.     

The Effect of SOX Internal Control Deficiencies on Firm Risk and Cost of Equity

The Sarbanes-Oxley Act (SOX) mandates management evaluation and independent audits of internal control effectiveness. The mandate is costly to firms but may yield benefits through lower information risk that translates into lower cost of equity. We use unaudited pre–SOX 404 disclosures and SOX 404 audit opinions to assess how changes in internal control quality affect firm risk and cost of equity. After controlling for other risk factors, we find that firms with internal control deficiencies have significantly higher idiosyncratic risk, systematic risk, and cost of equity. Our change analyses document that auditor-confirmed changes in internal control effectiveness (including remediation of previously disclosed internal control deficiencies) are followed by significant changes in the cost of equity that range from 50 to 150 basis points. Overall, our cross-sectional and intertemporal change test results are consistent with internal control reports affecting investors' risk assessments and firms' cost of equity.     

Dividend Policy and Market Valuation in British Industry

The objectives of the article are: firstly, to identify the principal factors which determine interfirm variation in dividend policy within the UK; and secondly, to examine the effect of dividend policy on company stock-market valuation. This cross-section empirical study is based on a random sample of 60 publiclyquoted British companies, and refers to the year 1970.
The Lintner (1956) model is rejected, in that capital requirements and earnings risk are seen to play an important part in determining dividend policy. The 'dividend neutrality' hypothesis is strongly rejected once risk and profitability-of-retained-earnings are taken into account.     

Do Large Banks Have Lower Costs? New Estimates of Returns to Scale for U.S. Banks

This paper presents new, fully nonparametric estimates of ray‐scale and expansion‐path scale economies for U.S. banks based on a model of bank costs. Unlike prior studies that use models with restrictive parametric assumptions or limited samples, our methodology uses local polynomial estimators and data on all U.S. banks over the period 1984–2006. Our estimates indicate that as recently as 2006, most U.S. banks faced increasing returns to scale, suggesting that scale economies are a plausible (but not necessarily only) reason for the growth in average bank size and that the tendency toward increasing scale is likely to continue unless checked by government intervention.