Academic journal article Journal of Managerial Issues

The Association between Auditor Size and Bank Regulator Ratings [*]

Academic journal article Journal of Managerial Issues

The Association between Auditor Size and Bank Regulator Ratings [*]

Article excerpt

The banking industry provides a unique opportunity to examine the effects of auditor choice on regulators. In banking, regulators provide (to bank directors and management) a direct measure of bank soundness based on predetermined, regulatory definitions and on-site examinations. The results of these regulatory assessments have immediate consequences for the bank. Bank regulators examine the quantity and quality of assets and liabilities and assess the adequacy of record-keeping and management controls. The choice of a high quality auditor potentially improves the regulators' evaluation of management control. Less directly, high quality auditors may enhance the regulators' assessment of assets and liabilities. In addition, choice of a high quality auditor indicates managers' willingness to be thoroughly reviewed and signals managers' competence and confidence. Accordingly, we consider the relation between regulatory evaluation results and auditor quality.

The empirical results suggest that auditor quality affects regulators' assessment of banks' financial condition. The choice of a Big 5 auditor is positively related to an overall bank rating, after controlling for the effects of other monitoring mechanisms and the underlying economic characteristics of the bank. We believe this result reflects regulators' response to the contribution of high quality auditors to the management control system, assets and liability measurement, and managers' signal of manager confidence. Bank managers' choice of a low quality audit firm prompts regulators to reduce their rating of the management control system, to increase suspicion of assets and liability measurement and/or to decrease their confidence in management.

BACKGROUND ON BANKING REGULATION

An important and effective tool of bank supervision and control is the bank examination. The bank examination process is the Federal Reserve's fact-finding arm in discharging its responsibilities (to safeguard depositors and prevent bank failures). The essential objectives of an examination are: (1) to provide an objective evaluation of a bank's soundness and compliance with banking laws and regulations, (2) to permit the Federal Reserve to appraise the quality of management and directors and (3) to identify those areas where corrective action is required to strengthen the bank, to improve the quality of its performance and to enable it to comply with applicable laws, rulings and regulations (Federal Reserve Commercial Bank Examination Manual, Section 1.1: 1).

Bank examinations generally occur once a year and require anywhere from a few days to several weeks. Examinations involve surprise, on-site visits by the regulators. The Federal Deposit Insurance Corporation Improvement Act of 1991 requires annual full-scope, on-site examinations. The exam period is extended to 18 months for well-managed, well-capitalized banks with less than $100 million in assets. The following two components of the examination process are addressed: (1) the recognition and evaluation of risks and (2) the responsibility of examiners to influence bank managers to take action. Examiners confirm the quantity and appraise the quality of all asset and liability accounts, evaluate bank operations and ensure compliance with regulations. They assess the adequacy of record-keeping and management controls (including external audits). On the basis of these reviews, the examiner rates the overall soundness of the bank by comparing its capital to its risk. Note that many of these activities are also pe rformed by the external auditor.

Examiners rank banks on each of five performance dimensions: (1) Capital adequacy, (2) Asset quality, (3) Management, (4) Earnings and (5) Liquidity. The acronym CAMEL is used to describe the system. Each bank is assigned a rating between one (the best) and five (the worst) on each of the criteria and an overall rating. The overall CAMEL rating is not a weighted combination of the individual CAMEL ratings, but represents the examiners' summary impression of the bank (Cargill, 1989). …

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