The Association Between Auditor Size and Bank Regulator Ratings [*].(Brief Article)

The coefficient on the variable of interest, AUDITOR, is positive and significant (p-value = .01). Regression results for RATING, defined as the bank's peer-group percentile ranking, are very similar to the national rating results (see Table 2). In this regression, the coefficient on AUDITOR is positive and significant with a p-value of .01. Both sets of estimates indicate that audit quality, proxied by auditor size, has a favorable effect on regulators' assessment of banks' safety and soundness. High quality auditors (versus low quality auditors) enhance the credibility of the bank's financial assertions, allowing the regulator to place greater reliance on reported financial performance and improving the regulators' assessment of control systems.

DISCUSSION

The Federal Deposit Insurance Corporation Act of 1991 (FDICA) requires bank managers (CEO and CFO) to report on the adequacy of the bank's internal control structure and financial reporting procedures. In addition, FDICA requires independent auditors to report on the assertions made by managers with respect to internal controls. Also, managers must document, and independent auditors must report on, bank compliance with safety and soundness regulations. Our empirical results indicate that auditor quality influences the review work of regulators. These results suggest the feasibility of further collaboration between external auditors and regulators.

The continued co-existence of bank regulators and auditors supports the notion that the two provide differentiated services. The demand for auditing arises out of the need to monitor contracts which rely on financial information. Managers engage auditors to certify contract compliance. To this end, auditors issue opinions which are distributed, with financial statements, to shareholders. Thus, auditors serve to verify financial information used in regulating the distribution of wealth between managers and shareholders. In contrast, government regulation of banks derives from the need to protect the public from unfair allocations of wealth. Bank managers submit to onsite regulatory examinations by order of law. Consistent with their charge, regulators submit reports only to the bank's board of directors and the focus of the report is correction. Consequently, regulators have enforcement powers to ensure compliance with their instructions and, therefore, certify the soundness of the bank (and the system) witho ut issuing public notice.

While the differentiated roles of examiners and auditors persist, our

empirical analysis suggests they may cooperate to ensure the credibility of bank financial information and the long-term survival of the institution. FDICA expands the exchange of documents between external auditors and regulatory examiners to include reports on the internal control system. Empirical support of the influence of auditor quality on regulatory examination results prompts the consideration of further cooperation between auditors and regulators. Despite their unique characteristics, auditors and regulators have a lot in common. Both perform on-site reviews of bank financial information, control systems and management. Both are concerned with the credibility of bank financial reports and the institution's long-term survival. Practitioners should investigate further opportunities for explicit cooperation between auditors and regulators. To the extent such cooperation reduces total examination costs without compromising regulatory oversight, regulators, bank managers and shareholders benefit. Auditors can also benefit from the increased efficiency of cooperative efforts.

The investigation of further cooperation has implications not only for practitioners (auditors and regulators), but also for researchers. Two avenues of additional research are evident. First, we can look for other bank monitors who perform duplicative services. Further opportunities for cooperation can be identified in an effort to reduce total monitoring costs. For example, investors in mortgage-backed securities may provide repetitive examinations of subject assets. A second research stream examines similar duplicative monitoring in other regulated industries. For example, utility companies face substantial regulatory scrutiny. Further research can examine possible savings generated by the cooperation between independent auditors and utility regulators.

The generalizability of industry-specific research is limited. The unique character of bank regulation, attributable to the nature of services provided and their central role in the economy, restricts the direct applicability of research methodology to other industries. Neither the regulatory environment nor the variable measurements transfer directly. In addition, this analysis is limited by the inability to capture regulatory evaluation results. While Sheshunoff rankings proxy for the overall bank rating assigned by examiners, Sheshunoff rankings derive from publicly available financial information. These rankings do not benefit from the on-site gathering of private financial and non-financial data which informs regulatory examinations.

CONCLUSION

In summary, we believe regulators, bank managers, and owners have cost incentives to reduce regulatory attention. Regulators, concerned about cost budgets and political exposure, have an incentive to take advantage of signaling mechanisms that indicate that the banks self-reported information is credible. Bank managers, interested in signaling that their financial reports and control systems are reliable, hire high quality auditors to indicate as much. If regulators recognize the incremental value that a high quality auditor provides, regulators may rely more on, and make an improved evaluation of the bank's management control system.

The findings are also important because they suggest that auditing, to some extent, could substitute for regulatory review. While auditors safeguard the interests of owners and regulators safeguard the interests of the depositors and dependents of the total banking system, these interests are aligned in that they ultimately focus on the bank as a going concern. Our empirical results suggest that audit quality (proxied by auditor size) positively influences regulators' assessment of banks' safety and soundness. To the extent that audit effort can substitute for regulatory effort, an opportunity exists to reduce costly redundant work performed by auditors and regulators.

(*.) We gratefully acknowledge the comments of Barb Chaney, Ted Christensen, Paul Copley, Skip Hughes, and workshop participants at Boston College, Texas Christian University, and the American Accounting Association Southwest Region Annual Meeting. We also acknowledge the research assistance of Mark Crossley and the financial support of the Charles Tandy American Enterprise Center.

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