The effect of bank governance on borrowers’ accounting choices

ABSTRACT

This study analyzes the effect of bank CEO appointment structure and tenure on borrowers’ accounting practices and earnings management. Drawing on agency theory, we posit that agency costs are high for banks that frequently change CEOs and those that appoint CEOs from external sources. The results indicate firms that borrow from banks with high agency costs adopt less conservative accounting practices and employ real activities earnings management when deteriorating management conditions lead to negative cash flow. This study provides a strong empirical foundation for future research by verifying that appointment structure and tenure of bank CEOs affect borrowers’ accounting choices.

KEYWORDS:

• Appointment structure
• bank governance
• earnings management
• borrower
• discretionary accruals

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. The CEO of EIBK, KDB, and WB Bank was appointed as the president’s alma mater financier, sparking controversy over government-controlled finance (Chosun Biz 2015; Ilyoseoul 2014).

2. When so-called ‘parachute’ or ‘revolving door’ executives were appointed from external organizations as political considerations, Kookmin Bank suffered internal conflict. Since these ‘parachute’ executives determined internal promotions, employees sought promotions by lining up behind these powerful executives, causing an increasingly distorted organizational culture (Hangyoreh Economic Daily 2014).

3. Thirteen former executives of the government-owned Korea Development Bank (KDB) were employed as high-ranking parachute executives, from presidents, vice-chairs, advisors, and auditors to outside directors, by subsidiary companies of Dongyang Group, whose main bank for ten years from 2003 to 2013 was KDB (Hankook Economic Daily 2014). Public officials monitor KDB, acting as shareholders. However, since public officials are government agents, they might slacken monitoring and supervision or overlook bank executives’ pursuit of personal interests (a simultaneous occurrence of both the shareholder-management agency problem and that of CEO-employees). This might be the result of thinking that the expected utility of loose monitoring and implicit approval is great enough to overlook default risk or to ‘highball’ the performance of the KDB in return for their own future parachute appointment to executive positions.

4. The rate of substandard loans (non-performing loans) of the EIBK increased substantially from 0.77 percent in 2010 to 2.02 percent in 2014. The rate of non-performing loans of the KDB was 2.66 percent as of the end of March 2015, which was greater than the average 1.39 percent of general national banks. Deceived by the fraud of the home appliances company Monuel, the EIBK issued loans to Monuel worth 113.5 billion won without securing collateral. The Financial Supervisory Service imposed sanctions on the KDB for approving loans to the STX group that amounted to accounting fraud worth 2 trillion won (Dong-A Ilbo 2015).

5. A main bank is a major bank that provides comprehensive loan services to a group of affiliated companies that are granted large loans from financial institutions pursuant to Clause 2 of Article 30 of the Bank Act (Limitation of Loans to Groups of Affiliated Companies) and related regulations.

6. Chair of the Korea Federation of Banks, Young Goo Ha, said low domestic bank profitability is closely related to bank governance attributes, such as the short tenure of bank CEOs. While the key interest rate in the USA is zero and that in Korea is 1.5 percent per annum, the net interest margin of the US banks averages 2.5 percent, which is twice as high as that of Korean banks. This is related to the frequent replacement of the CEO. With a short tenure, bank CEOs tend to focus more on quantitative growth aspects, such as assets and loans, rather than on enhancing profitability or shareholder value (Hankook Economic Daily 2015).

7. The results of Basu’s (1997) conservative model show that the variables of interest are not significant, unlike the conservative model of Ball and Shivakumar (2005, 2006). These results can be explained as follows. While Basu’s (1997) conservative model is based on the ‘efficient markets hypothesis,’ where good news and bad news are immediately fully reflected in stock prices, Korea’s capital market might not reflect disclosed information efficiently enough. It might also be the influence of unidentified variables omitted from this study’s model. Moreover, there are factors that decrease net profit while boosting stock prices, a limitation of Basu’s (1997) conservative model. For example, when a company recognizes bad debt expenses such as non-performing loans and impairment losses in the current fiscal year because it is confident of generating future profits, contrary to general expectations, the stock price might rise further, reflecting this confidence. Hence, this study verifies the hypothesis using Ball and Shivakumar (2005, 2006) model, which measures conservatism by recognizing the difference between cash flow and accruals.

Additional information

Funding

This work was supported by the Seoul Theological University [Seoul Theological University Research Fund of 2020].