Securities Underwriting and Discretionary Financial Reporting Behavior

• In Event: Financial Institutions and Discretionary Behaviour

Abstract

We investigate changes in the discretionary financial reporting behavior of banks with Section 20 subsidiaries, following the Federal Reserve’s replacement of the firewalls governing the relationship between bank holding companies and their securities affiliates (Section 20 subsidiaries) with less restrictive operating standards. The combination of lending and underwriting activities within one bank is a source of concern for depositors of the bank, investors in its equity, and regulators. We test whether Section 20 banks change their propensity to signal through loan loss provisions to alleviate concerns about the quality of the issues they underwrite. We also test whether these banks change their propensity to smooth through loan loss provisions to alleviate concerns about the riskiness of the Section 20 activities compared to traditional banking. We find that Section 20 banks engage in more signaling and less smoothing, and that, on a net basis, these changes in discretionary financial reporting reduce the reliability of loan loss provisions as a predictor of future loan defaults.

Authors

• Arthur J Francia, University of Houston

• Emre Kilic, University of Houston

• Christian S. Kuiate, University of Houston

• Gerald Lobo, University of Houston