Bank Competition and Opacity
with Chen Lin, the University of Hong Kong, and Liangliang Jiang, Lingnan University
In our new paper, “Competition and Bank Opacity,” my co-authors, Chen Lin of the University of Hong Kong and Liangliang Jiang of Lingnan University, and I provide the first evaluation of the impact regulatory reforms that spurred greater competition among banks on the quality of information disclosed by banks to the public. We test whether a regulatory-induced intensification of competition among banks increases, decreases, or has no effect on bank opacity.
Some economists propose that greater competition will compel firms to adopt enhanced corporate governance mechanisms, potentially leading to more transparent, higher quality financial statements, to attract funds from investors. In contrast, others argue that competition increases opacity by either inducing firms to manipulate financial statements to hinder the entry of potential rivals or by spurring executives to engage in unethical behavior, including more aggressive accounting practices, to extract as much as possible before competition puts the company out of business.
To evaluate the impact of bank competition on opacity, we examined the removal of regulatory impediments to bank competition among U.S. banks during the last quarter of the 20th century. Interstate bank deregulation eased the regulatory impediments faced by bank holding companies headquartered in one state wanting to establish subsidiaries in other states. These reforms progressed in a chaotic, state-specific process of bilateral and multilateral agreements over two decades that spurred competition among banks.
We use two measures of bank opacity. First, we use the frequency with which banks restate their earnings with the Securities and Exchange Commission (SEC). Restatements imply that banks misstated their financial statements and needed to correct their reports with the SEC. While not all restatements involve earnings management, the incidence of earnings management is positively associated with them.
The second measure focuses on loan loss provisions (LLPs), which are the most important tool used by banks to manage earnings and regulatory capital. There are numerous models for estimating and predicting corporate LLPs, backed by extensive study. This literature also uses these models to calculate the difference between a model’s prediction of a bank’s LLPs and the bank’s reported LLPs—and uses this gap as a measure of the degree to which the bank manipulates its financial statements. While all models have errors, one reason the gap between a model’s predicted LLP and a bank’s reported LLP could grow is if the bank’s managers are manipulating reported earnings, as such manipulations are not included in a given model.
With both measures of opacity, we find that a regulatory-induced increase in bank competition spurs a sharp reduction in bank opacity. The economic benefits to individual firms are substantial. After a state deregulates restrictions on the ability of bank holding companies in another state to enter and compete, we find that bank opacity falls by about half.