Reliance on Third Party Verification in Bank Supervision

• In Event: Research in Financial Accounting

Abstract

We examine how internal control regulation affects bank supervision by exploiting a change in size thresholds for required FDICIA-related internal control audits. We document that affected banks increase their reported non-performing loans after the removal of internal control audit requirements compared to unaffected banks. This increase in non-performing loans is accompanied by increases in loan loss provisions and loan charge-offs but not increases in past due loans, indicating more forthcoming reporting rather than operational deterioration. Furthermore, we find that the effects are concentrated in periods of heightened regulatory scrutiny and in banks with less stringent oversight in the pre-period. In turn, examiners downgrade regulatory ratings, indicating an increase in stringency after the elimination of third-party verification of internal controls over financial reporting. Our findings suggest that third-party verification is an imperfect substitute for bank supervision and efforts to rely upon externally generated attestations may heighten bank risk.

Authors

• Yadav Krishna Gopalan, Indiana University - Bloomington

• Andrew John Imdieke, University of Notre Dame

• Joseph H Schroeder, Indiana University - Bloomington

• Sarah B Stuber, Michigan State University