Bank Audit, Regulatory Costs and Strategic Growth

• In Event: Auditor Selection

Abstract

Section 36 of the Federal Deposit Insurance Corporation (FDIC) Act requires banks with asset size larger than $500 million to have a mandatory audit. We empirically examine whether banks close to the $500 million threshold strategically grow less quickly to avoid being audited and how they make cost-benefit trade-off decisions on their asset growth. We find that banks around the regulatory size cutoff strategically slow their asset growth, suggesting that they perceive a net cost of growing and being audited. In the cross-section, we find less strategic growth behaviour in banks with higher cost of debt. The result implies that there is substitution effect between the monitoring from depositors and auditors and banks perceive it to be an audit benefit. In addition, we find the strategic growth behaviour is more prevalent in banks operating in worse-performing local economies and concentrated markets, implying that banks consider the opportunity costs of remaining small to be lower in those markets. The result also highlights the negative impact of the regulation on liquidity provision, especially in the concentrated and poor-performing markets. Finally, we find contagion effects of strategic growth among banks located in the same area, suggesting that banks learn the cost and benefit trade-off decisions from their peers and tend to grow similarly.

Author

• Pauline Wu, The University of British Columbia