Banks’ Survival During the Financial Crisis

The following post comes to us from Jeffrey Ng of the Sloan School of Management and Tjomme Rusticus of the Kellogg School of Management.

In our paper, Banks’ Survival during the Financial Crisis: The Role of Financial Reporting Transparency, which was recently made publicly available on SSRN, we focus on how financial reporting quality affects bank stability by examining the relation between bank transparency and regulatory intervention in the form of enforcement orders and bank closures. Enforcement orders are issued against banks in which a federal regulator such as the Federal Reserve, the OCC, or the FDIC has found unsafe or unsound banking practices and violations of law and/or regulations. A bank closure, also known as a bank failure, generally refers to the closing of a bank by a federal or state banking regulatory agency due to concerns that the bank will be unable to meet its obligations to its depositors or other creditors.

We use two measures of financial reporting quality derived from the Consolidated Reports of Condition and Income that banks file quarterly with their regulators. For our first measure of financial reporting quality, we focus on the quality of the loan loss provisioning process; this process is an important accounting process through which banks recognize loan losses in a more timely fashion so as to better match the expenses and revenue of loan making. Consistent with regulatory statements that banks should make appropriate loan loss provisions to adjust for the economic conditions they face, we argue that loan loss provisions are of a higher quality if there are smaller deviations (over a period of time) from an economic model of loan loss provisions. This interpretation, that more noise in a signal is an indication of lower quality, is also consistent with disclosure theory and the extensive empirical literature on earnings quality. We complement this measure using a second reporting quality measure based on the incidence of accounting restatements. Consistent with prior literature on model-based measures of accounting quality and restatements, we find that the relation between our two measures is in the predicted direction and is highly statistically significant.

Using these measures of reporting quality, we investigate the effect of bank transparency on bank stability and on several potential mediating mechanisms: bank capital, non-performing loans, and profitability. We provide evidence that poor loan loss provision quality and a higher incidence of restatements is associated with a higher likelihood of subsequent regulatory intervention and bank failures. We also examine some of the underlying mechanisms through which financial reporting quality could lead to these associations. One obvious mechanism is the level of non-performing loans, because one might expect banks with poorer information for decision making and monitoring to end up with lower quality loans, which lowers profitability and attracts regulatory interventions. We provide evidence consistent with these mechanisms. While the reduced profitability lowers capital ratios ex-post, the greater uncertainty caused by lower loan loss provision quality could lead to higher capital ratios ex-ante (Diamond and Rajan, 2000). Consistent with these two competing forces, our evidence on the relation between transparency and capital ratios is mixed. Finally, we investigate whether reporting quality affects the effectiveness of regulatory intervention. We find that, conditional on regulatory intervention, banks with higher loan loss provision quality have a lower failure rate.

Our paper adds to a growing literature that studies the problems that banks faced during the recent financial crisis. For example, Veronesi and Zingales (2010) study the cost and benefits of the government intervention among banks that were the first to participate in the Capital Purchase Program under the broader Troubled Assets Relief Program (TARP). Demyank and Van Hemert (2009), Ivashina and Scharfstein (2010), Keys, Mukherjee, Seru, and Vig (2010), and Beatty and Liao (2011) examine the lending behavior of banks before and during the financial crisis. Campello, Graham, and Harvey (2010) study the real effects of financial constraints during the crisis. Gorton and Metrick (2011) characterize the crisis as a run on the sale and repurchase (repo) market. Unlike these papers, we focus on the role of bank transparency in mitigating the adverse events that banks faced during the crisis.

To the best of our knowledge, we are the first to empirically study the relation between transparency (in terms of loan loss provision quality and restatements), regulatory enforcement and bank failures. In our analyses, not only do we examine the relation between bank transparency and regulatory intervention, we also study the underlying mechanisms through which bank transparency could impact regulatory intervention. From a policy reform perspective, our finding that greater transparency increases bank stability and improves the effectiveness of regulatory intervention supports the push by various regulators for greater bank transparency so as to increase bank stability.

The full paper is available for download here.

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  1. Carlos N. Mancini
    Posted Monday, August 8, 2011 at 11:10 am | Permalink

    The “Federal regulation of the banking sector in the United States” has to be revised. The Office of Thrift Supervision is part of the “Office of the Comptroller of the Currency.”

  2. Jeffrey Ng
    Posted Saturday, August 13, 2011 at 1:35 pm | Permalink

    We thank Carlos for his comment. Our description of the regulation was for the period before crisis. We will add a footnote indicating the following: “On July 21, 2011, the Office of Thrift Supervision became part of the Office of the Comptroller of the Currency.”