Internal Control Quality and Bank Risk-Taking and Performance.

• In Event: Internal Controls and Firm Performance

Abstract

Bank regulators have long asserted the importance of internal controls in enhancing the safety and soundness of the banking systems. However, it is unclear whether internal controls improve bank risk-taking and performance. Using two proxies for internal control quality, unremediated material weaknesses and quarterly abnormal loan loss provisions, we find that strong internal controls both reduce risk and increase performance. Additionally, we find that banks with material weaknesses are more (less) likely to experience extreme negative (positive) performance, suggesting that internal controls are effective at helping banks engage in more efficient risk-taking. We also find that internal controls affect performance directly as well as indirectly through risk-taking. The results are economically meaningful. For example, a bank that discloses first-time material weaknesses in 2007 has approximately 50 percent more non-performing loans and stock returns that are 1.8 times lower during the crisis period compared to banks without material weaknesses in 2007.

Authors

• Matthew Baugh, Arizona State University

• Matthew Stephen Ege, Texas A&M University

• Christopher G Yust, Texas A&M University