Bank accounting regulations, enforcement mechanisms, and financial statement informativeness: cross-country evidence^*

* Portions of this work were finished when Dr Song visited the Bank of Finland.

Abstract

We construct measures of accounting regulations and enforcement mechanisms that are specific to a country's banking industry. Using a sample of major banks in 37 economies, we find that the informativeness of banks’ financial statements, measured by the value relevance of earnings and common equity, is higher in countries with stricter bank accounting regulations and countries with stronger enforcement. These findings suggest that superior bank accounting and enforcement mechanisms enhance the informativeness of banks’ financial statements. In addition, we find that the effects of bank accounting regulations are more pronounced in countries with stronger enforcement in the banking industry, suggesting that enforcement is complementary to bank accounting regulations in achieving higher value relevance of financial statements. Our study has important policy implications for bank regulators.

Keywords:

• bank accounting regulations
• industry-specific enforcement mechanisms
• financial statement informativeness
• banking transparency

JEL Classification:

• M41
• M48

Acknowledgements

We thank Stergios Leventis (the guest editor), Mark Clatworthy (editor), Juan Manuel Garcia Lara (editor), Edward Lee (editor), two anonymous referees, Sudipta Basu (discussant), and other workshop participants at the 2017 American Accounting Association Annual Conference for their helpful comments and suggestions. We gratefully acknowledge the financial support provided by the Kogod Research Grant at American University.

Disclosure statement

No potential conflict of interest was reported by the authors.

ORCID

Iftekhar Hasan http://orcid.org/0000-0003-2469-0539

Notes

* Portions of this work were finished when Dr Song visited the Bank of Finland.

1 One major argument for prudential bank regulation is bank-depositor information asymmetry (Beatty and Liao 2014).

2 The importance of market discipline and bank supervision is underscored by the fact that two of the three pillars of the recent international prudential standards, Pillar 2 and Pillar 3 in the Basel II and Basel III Regulatory Frameworks (Basel Committee on Banking Supervision 2006, 2011), focus on these enforcement mechanisms. Both market discipline (Pillar 3) and supervision (Pillar 2) are complementary and self-reinforcing in their twin goals of mitigating problems of both moral hazard and asymmetric information that are endemic in the banking industry. Pillar 1 deals with minimum bank capital requirements.

3 For example, if accrued, though unpaid interest on nonperforming loans is not allowed to enter the income statement, it reduces bank managers’ ability to overstate earnings (and thus bank capital). As another example, not all countries require financial institutions to produce consolidated accounts covering all bank and any non-bank financial subsidiaries. Obviously, compared with the financial statements of the parent bank firm alone, consolidated statements are more informative and can better summarize information that influences the value of the entire group including the parent firm and its subsidiaries.

4 Earlier studies (e.g. Daske et al. 2008, Christensen et al. 2016) generally use the rule-of-law or security regulation indices to measure the strength of enforcement. However, these measures are deficient in capturing compliance with accounting regulations per se (Brown et al. 2014).

5 Ball et al. (2003) note the important role of the private sectors in enforcing accounting standards, in particular, in common-law countries. Indeed, market discipline and regulatory supervision are closely related in the banking industry. Market discipline not only exerts direct influence on banks, but also triggers regulatory intervention by transferring market signals such as price movements of bank securities (e.g. Rochet 2005, Stephanou 2010).

6 La Porta et al. (1998) and Hope (2003) discuss the possibility that a country may substitute strong legal enforcement for weak laws and rules, though this possibility is not supported in their studies.

7 According to Barth et al. (2001, 2008a), most of the responses to the first survey were received during 1998–1999, and a small number of the responses were received in 2000.

8 Barth et al. (2001, 2004, 2006, 2013) describe the survey questions and data collection process in detail.

9 For example, as the comparison between surveys in 2006 and 2010 shows, Chile and Peru increased their bank accounting regulations from 5 to 6 during this period.

10 For the use of a similar type of IVs, see Acemoglu et al. (2015) and Delis et al. (2017).

11 We appreciate an anonymous referee for suggesting this test.