Banks tend to use opaque financial reporting to facilitate regulatory forbearance

By Grace Segran

SMU Office of Research & Tech Transfer – The banking system is at the heart of a country's financial infrastructure, and the system's effective functioning is critical to resource allocation and economic stability and prosperity.

“Transparent financial reporting can promote the effective functioning of the banking system by facilitating corporate governance, government supervision, and market discipline,” says Lee Kong Chian Professor of Accounting Liandong Zhang. His research paper “The Politics of Bank Opacity” was published in a recent issue of the Journal of Accounting and Economics.      

The 2007-2009 financial crisis attracted a lot of attention from accounting academics on understanding factors that contribute to the opacity of banks. The focus on the effect politics have on bank opacity was motivated by the view that modern banking is a partnership between the government and a group of bankers.

“Calomiris and Haber (2014) argue that the partnership is shaped by institutions that govern the distribution of power in the political system and show that most banking crisis in history originated from political institutions,” adds Professor Zhang.

Bank opacity/transparency

Bank opacity or transparency measures the difficulty for external stakeholders, such as depositors, investors, and taxpayers, to understand what is going on within the banks.

For example, transparent financial reports make it easier for external parties to understand bank operating and investing activities and facilitate the monitoring of banks by various external stakeholders. In contrast, bank opacity can hinder effective monitoring of banks and lead to excessive bank risk-taking, which in turn, increases the systemic risk of the financial system and the likelihood of a financial crisis, Professor Zhang argues.

In this study, Professor Zhang and his research team examine whether the distribution of political power that governs the banking sector affect the financial opacity of banks.

“In particular, we examine how the presence of a senator on the influential U.S. Senate Committee on Banking, Housing, and Urban Affairs (i.e., Senate Banking Committee) affects the financial reporting opacity of banks headquartered in the senator’s home state. In addition, we examine the potential mechanisms for such an effect, if it exists,” he told the Office of Research and Tech Transfer.

To examine the team’s research question, they assembled a large financial dataset of bank-quarter observations over the period 1995 to 2017.  Using the dataset, the team calculated empirical measures of bank opacity and key control variables. They also manually collected the historical data on the membership of the Senate Banking Committee from the annual volumes of the Official Congressional Directory. Then they conducted a generalised difference-in-differences regression analysis. 

Relationship between politicians and bank opacity

The Senate Banking Committee has jurisdiction over matters related to banks and financial institutions, deposit insurance, monetary and credit policy, financial aid, and economic stabilisation, among others.

According to congressional control theory, the senators on the Senate Banking Committee (BC senators) can influence the actions of banking regulators via various monitoring, rewarding, and punitive mechanisms, such as budgetary appropriation confirmation and oversight and investigative hearings on the performance of banking regulators.

“BC senators can also influence bank regulators via their advice and consent power to confirm these officials,” explains Professor Zhang.

Bank failures can impose substantial negative externalities on the economy, especially the economy of the states where banks are located, dimming the career prospects of politicians. Due to political career concerns, senators on the Banking Committee have incentives to use their power to mitigate the negative consequences of bank failures in their home states.

However, BC senators may have a positive effect on bank opacity through the interactions of banks, senators, and regulators. During periods of financial distress, BC senators have incentives to press government officials to give preferential treatment to banks in their home states in the allocation of bailout funds.

“For example, according to a Wall Street Journal article, during the 2007–2009 financial crisis, powerful politicians appeared to use their leverage to direct millions of Troubled Asset Relief Program (TARP) money toward banks in their home states,” avers Professor Zhang.

Anticipating BC senators’ strong ability and incentive to save them during financial distress, banks will take more risks, which might be considered excessive by regulators or market participants. To shield themselves from disciplinary actions by the regulators or the market, these banks have incentives to make their financial reports more opaque.

Findings

The researchers found that banks headquartered in states with BC senators have significantly higher levels of discretionary loan loss provisions, the proxy for bank opacity, than their peers in states without BC senators. The result is stronger for larger banks and for banks with higher risk.

“In investigating the mechanisms involved, we find that BC senators have a negative effect on the likelihood of banks in their home states receiving enforcement actions, and, more importantly, this effect is stronger for more opaque banks,” says Professor Zhang. “The effect of BC senators on bank opacity and the interactive effect of BC senators and opacity on enforcement actions are more pronounced when the senators wield more political clout.”

These findings suggest that politicians, regulators, and banks employ opaque financial reporting to facilitate regulatory forbearance. Regarding real effects, the researchers found that BC senators are associated with more future loan losses and a higher risk of bank insolvency, and that bank opacity is a significant channel through which BC senators affect these real outcomes. During economic downturns, however, BC senators appear to promote bank opacity to encourage bank lending and create liquidity. Finally, the capital market does not appear to penalise the reporting opacity of banks in states with BC senators.

Conservatives vs Liberals

They also found some interesting results that the ideology of the politicians matter. In particular, the researchers found that the effect of BC senators on bank opacity is largely driven by senators that are considered liberals.

“Conservatives tend to oppose spending public resources on private sector bailouts, whereas liberals prefer more government intervention,” opines Professor Zhang. “For example, prior study shows that Republicans tended to vote against the TARP bill during the 2008–2009 financial crisis. If banks expect a lower likelihood of bailouts from conservatives, we would expect banks linked to conservative BC senators to be likely to take less excessive risks.”

Moreover, conservatives are more likely to leave banks to the disciplinary power of the free market and are thus less likely to shield banks from market discipline. Both arguments suggest that there is a lower demand for opacity from banks in states with conservative BC senators than in states with BC senators that are liberals.

This study feeds directly into Professor Zhang’s main area of interest which is to understand the determinants and consequences of the quantity and quality of corporate financial reporting and disclosure.

“I am interested in this area because corporate financial reporting and disclosure play a central role in supplying information to the financial market. In fact, I believe they are the critical foundation of a functioning financial market,” he says.

Back to Research@SMU Feb 2022 Issue