Do Strict Regulators Increase the Transparency of Banks?

• Published date: 01 June 2019
• Author: JOSEPH WEBER,JOÃO GRANJA,ANNA M. COSTELLO
• DOI: http://doi.org/10.1111/1475-679X.12255
• Date: 01 June 2019

DOI: 10.1111/1475-679X.12255

Journal of Accounting Research

Vol. 57 No. 3 June 2019

Printed in U.S.A.

Do Strict Regulators Increase the

Transparency of Banks?

ANNA M. COSTELLO,

∗JO˜

AO GRANJA,

†AND JOSEPH WEBER

‡

Received 19 June 2015; accepted 8 November 2018

ABSTRACT

We investigate the role that regulatory strictness plays on the enforcement of

financial reporting transparency in the U.S. banking industry. Using a novel

measure of regulatory strictness in the enforcement of capital adequacy, we

show that strict regulators are more likely to enforce restatements of banks’

call reports. Further, we find that the effect of regulatory strictness on ac-

counting enforcement is strongest in periods leading up to economic down-

turns and for banks with riskier asset portfolios. Overall, the results from our

study indicate that regulatory oversight plays an important role in enforcing

financial reporting transparency, particularly in periods leading up to eco-

nomic crises. We interpret this evidence as inconsistent with the idea that

∗Ross School of Business, University of Michigan; †Booth School of Business, University of

Chicago; ‡Massachusetts Institute of Technology, Sloan School of Management.

Accepted by Douglas Skinner. We thank Amit Seru for generously providing access

to the U.S. Bank Regulatory Index data set. We also thank Brad Badertscher, Mary

Barth, Jannis Bischof, John Core, Peter Demerjian (discussant), Miguel Duro (discus-

sant), Miguel Ferreira, John Gallemore, Michelle Hanlon, Christian Leuz, Thomas Rauter,

Amit Seru, Rahul Vishishtha, Dushyantkumar Vyas (discussant), and workshop participants

at Carnegie Mellon University, London Business School, MIT, Rice University, Washing-

ton University (Olin), UNC Kenan-Flagler Business School, Faculdade de Economia do

Porto, Universit¨

at Mannheim, and participants of the Colorado Accounting Conference,

Lisbon Accounting Conference, and Minnesota Empirical Conference for comments. Fi-

nally, we thank Suzie Noh for stellar research assistance. Jo˜

ao Granja gratefully acknowl-

edges the support of the MIT Sloan School of Management (his previous affiliation) and

the support of the William Ladany Faculty Research Fund at the University of Chicago

Booth School of Business. An online appendix to this paper can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

603

CUniversity of Chicago on behalf of the Accounting Research Center,2019

604 A.M.COSTELLO,J.GRANJA,AND J.WEBER

strict bank regulators put significant weight on concerns about the potential

destabilizing effects of accounting transparency.

JEL codes: E58; G21; M40; M41

Keywords: banking; accounting transparency; regulation; regulatory en-

forcement; accounting restatements

1. Introduction

According to a prominent narrative of the recent financial crisis, lax regula-

tory enforcement of financial reporting transparency in the banking sector

was a key contributor to the buildup of risks that preceded the problems

in the financial system.1Investors, market participants, and members of

the financial press alleged that banking regulators catered to the interests

of the financial industry and failed to enforce financial reporting trans-

parency. Others claimed that banking regulators loosened their enforce-

ment of financial reporting transparency to insulate banks from market

pressures that would have forced them to further cut lending and sell as-

sets at already discounted prices (e.g., Hanson, Kashyap, and Stein [2011],

Beatty and Liao [2014]). However, there is little empirical evidence about

whether regulators tightened or loosened their oversight of banks’ finan-

cial reporting over the last business cycle. We provide evidence on the role

of regulators in enforcing financial reporting transparency before, during,

and in the aftermath of the financial crisis.

We use a novel measure of regulatory strictness in the enforcement of

capital adequacy to provide evidence on the relation between regulatory

oversight and financial reporting transparency.2Agarwal et al. [2014] ex-

ploit the predetermined rotation schedule of state and federal regulatory

examinations to develop an index of the strictness of each state bank regu-

lator. This measure captures the average difference between the confiden-

tial regulatory ratings assigned by state regulators and the rating assigned

to the same bank by federal regulators. The authors document that a softer

stance of state regulators relative to their federal counterparts is associated

with negative outcomes, such as higher bank failure rates and a lower likeli-

hood of repayment of funds borrowed under the Troubled Asset Relief Pro-

gram (TARP). We build on their paper under the assumption that stricter

regulators are associated with better banking outcomes. Our paper asks

1For examples of these arguments, see “The Financial Crisis and the Role of Fed-

eral Regulators,” from the Hearing Before the Committee on Oversight and Govern-

ment Reform on October 23, 2008 (http://www.gpo.gov/fdsys/pkg/CHRG-110hhrg55764/

html/CHRG-110hhrg55764.htm). During these hearings, Christopher Cox, then chairman of

the Securities and Exchange Commission (SEC), suggested that the lack of financial reporting

transparency contributed to the financial crisis by letting risks grow “in darkness.”

2Throughout the paper, we use the terms “regulatory strictness” or “strict regulator” inter-

changeably with the phrase “regulatory strictness in the enforcement of capital adequacy.”

DO STRICT REGULATORS INCREASE THE TRANSPARENCY OF BANKS?605

whether strict regulators that perform well on a number of dimensions are

also more likely to enforce higher reporting transparency. Conceptually,

the relation between strict regulatory enforcement and financial report-

ing transparency is ambiguous. For example, strict state regulators may be

less likely to enforce reporting transparency if they perceive that enforc-

ing transparency could potentially destabilize sound financial institutions.

Thus, it is an empirical question whether strict regulators that perform well

on a number of dimensions enforce higher or lower transparency.

Our measure of regulatory enforcement of financial reporting trans-

parency is the likelihood of regulatory restatements. Regulators audit the

content of regulatory reports during on-site examinations. A restatement

captures the extent to which the regulator takes actions to correct account-

ing mistakes, errors, and irregularities that misstate reported capital. We

interpret a greater incidence of regulatory restatements as enhancing the

accuracy and reliability of financial reports, thereby improving the bank’s

transparency. Our measure of transparency is distinct to our setting and

captures the regulator’s role in enforcing reliable reporting of regulatory

capital. Other papers define transparency in the banking sector as disclo-

sures that increase the precision of the public signals about banks’ financial

condition (e.g., Goldstein and Sapra [2014], Parlatore [2015]).3

One possible concern with using regulatory restatements as a measure

of reporting transparency is that differences in restatement rates across

regulators might reflect differences in the quality of financial reporting

across banks rather than differences in regulators’ ability, objectives, and

resources devoted to enforcing transparency. Our identification strategy re-

lies on the assumption that state and national banks operating in the same

areas are subject to similar economic shocks and have similar business mod-

els.4However, the regulatory enforcement of state and national banks op-

erating in the same areas likely differs substantially. The oversight of state

banks depends on the idiosyncratic characteristics of local state banking

authorities, including their ability, objectives, and resources. By contrast,

a single federal regulator oversees national banks and thus should not ex-

hibit much variation in their oversight across different states. We use the

incidence of accounting restatements of national banks as a baseline for

the expected rate of accounting restatements of state banks located in the

same regions. In doing so, we control for the role of the bank’s local eco-

nomic incentives in shaping reporting transparency, allowing us to better

isolate the role of differences in regulatory enforcement.

3In supplemental analyses, we test our hypotheses using other measures of reporting trans-

parency.

4Until the 1980s, different charters implied significant differences in regulatory require-

ments, and therefore the incentives of state banks likely differed from that of national banks.

However, Blair and Kushmeider [2006] document that since the 1980s, these differences dis-

appeared; banks now mainly select their charter based on regulatory costs and regulators’

accessibility. Any remaining heterogeneity in state versus national bank charter should be ab-

sorbed through our fixed effects.