Academic journal article Economic Review (Kansas City, MO)

Bank Financial Restatements and Market Discipline

Academic journal article Economic Review (Kansas City, MO)

Bank Financial Restatements and Market Discipline

Article excerpt

When banks misreport financial information, they receive extensive scrutiny from regulators, investors, and the financial press. Banks may reissue financial statements for several reasons, ranging from simple accounting or clerical errors to fraud. But regardless of the reason, financial restatements send negative signals to the public, creating uncertainty about bank stability and potentially damaging banks' reputations. Bank stakeholders--including shareholders, depositors, and loan customers--may interpret misreporting as increased risk and take actions that impose costs on the restating bank. These actions constitute "market discipline" and may incentivize banks to report financial information accurately.

Whether financial restatements impose discipline on banks is an empirical question. Shareholders may respond to the perception of increased risk by selling stocks of restating banks, which may reduce stock prices and increase the bank's cost of equity. At the same time, depositors may withdraw funds or require higher interest rates on deposits, thereby increasing the bank's cost of deposits. In addition, loan customers may demand fewer loans or lower interest rates from the restating bank, reducing its earnings. Together, these actions could be very costly to banks.

However, regulatory considerations may blunt these disciplinary effects. Strict bank regulations might reduce concerns arising from financial restatements if stakeholders believe these regulations prevent excessive risk-taking. In addition, some stakeholders might view large banks as "too big to fail," shielding them from potential losses. Finally, most bank deposits are federally insured, potentially relieving depositor concerns about safety.

In this article, we investigate whether shareholders, depositors, and loan customers discipline banks that misreport financial statements. We find strong empirical evidence that they do. First, we find that bank stock returns decline following a restatement, suggesting that shareholders respond to financial restatements. The effects are stronger for large banks, which are likely owned by more sophisticated institutional investors. Second, we find that depositors withdraw funds at restating banks. The deposit outflow is larger for uninsured depositors, who have greater monitoring incentives, and smaller at larger banks, perhaps due to implicit and explicit government guarantees. Third, we find some limited evidence that restatements affect loan growth, as consumer lending slows marginally. However, these effects could be due to changes in funding availability. Overall, stakeholders' reactions to bank restatements are economically important, resulting in significantly higher costs for the restating banks, consistent with market discipline.

Section I discusses market discipline in banking and bank stakeholders' reactions to financial restatements. Section II discusses the data sources and presents the empirical framework relating bank restatements to shareholder reactions. Section III shows that stock returns, deposits, and loan growth slow aftet banks reissue their financial statements.

I. Responses to Misreporting and Market Discipline

Accurate financial reporting is critical for well-functioning financial markets. When banks release inaccurate information or do not comply with accounting rules or standards, they may restate their financial disclosures, either voluntarily or at the request of an auditor or regulator. These restatements are publicly announced, informing stakeholders that prior financial statements may have contained errors or omissions. Restatements may damage banks' reputations by raising concerns about their internal controls as well as the reliability of future reports. Moreover, restatements may cause stakeholders to reassess firm value in light of new information.

Because banks are informationally opaque--that is, difficult for outsiders to assess and monitor--financial misreporting may trigger market discipline (Furfine 2001; Morgan 2002). …

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