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

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).

Empirical evidence suggests that investors have more confidence in bank financial reports following regulatory assessments. News about a regulatory examination is likely to leak to the public. While examination results are not public information, financial reports released soon after the examination are likely to be more accurate. Empirically, they find that inspections increase the market value of the bank's equity by reducing the uncertainty of reported values. Similarly, Berger and Davies (1998) and DeYoung et al. (1998) find the regulatory assessments contain information useful to the market even though the assessments are supposedly confidential.

From the perspective of bank owners, the punitive costs of poor examination results elevate the status of regulators as a concerned bank constituent. From the perspective of bank managers, the possibility of direct regulatory intervention by the Federal Reserve also elevates the status of the regulator. Houston and James (1993) document regulatory effectiveness in terms of one enforcement activity, namely, to discipline poorly performing managers. Houston and James find that the frequency with which regulators remove top management from financially troubled banks is similar to the frequency with which non-regulatory monitors take such actions in other distressed firms. Among banks announcing senior management changes, asset sales, changes in dividend policy, acquisition activity or any oversight activity, the chief executive officer was replaced in 33.6 percent of the institutions. To further explore the influence of regulatory activity, Houston and James compared the frequency of turnover among firms that w ere not subject to oversight (22 percent) to the turnover rate in firms subject to regulatory oversight (70 percent). Additionally, the cost of these actions to the subject managers, in terms of lost income and future opportunities, is substantial, suggesting that bank managers bear the consequences of financial distress.

In summary, the uniform system of CAMEL ratings is a ranking measure used to identify troubled banks. The higher the CAMEL rating, the more regulatory attention the bank receives. Black et al. (1978) point out that troubled banks receive more regulatory attention than non- troubled banks. If the regulator dedicates more effort to a troubled bank, and the respective bank management spends more effort responding to regulatory concerns, then the increase in regulatory attention should be reflected in a real increase of bank and regulatory costs. Poor bank ratings also impose costs in terms of restrictions on bank activities, prohibition of mergers and acquisitions and even branch or bank closure. These incremental costs may provide an incentive for managers and regulators to rely upon audit quality as a way to mitigate these costs. In the next section we discuss these cost effects and how they lead to predictable hypotheses about the relation between audit quality and regulatory assessments.

THEORY AND HYPOTHESIS

Regulatory Costs

Increased regulatory attention is costly to the bank and its management. Banks incur two costs related to more frequent or more detailed examinations. First, the insurance premium paid to the Federal Deposit Insurance Corporation (FDIC) is a risk-related charge. The charge is based on qualified deposits at the bank and adjusted for risk using the CAMEL rating. Typically, national banks pay about $1.25 of insurance premium for every $100 of deposits. An example of the impact of CAMEL ratings on insurance premiums is provided in Cocheo (1995). Cocheo (1995) reports that in 1993 examiners issued higher (i.e., poorer) CAMEL ratings for the National Bank of Rising Sun, Rising Sun, Md., a small bank with about $83 million in assets. During the next six months, FDIC insurance premiums increased by $13,500 due to the poorer CAMEL ratings.

A second cost from increased regulatory attention is the fact that bank staff and management are distracted from their normal responsibilities to prepare reports, gather documents and respond to questions. Additionally, receiving poor CAMEL ratings from bank examiners restricts the bank managers' ability to raise capital, reduces the managers' compensation, limits the accumulation of human capital, and decreases the managers' credibility (Gargill, 1989). Williams and Jacobsen (1995) report that banks spend up to 14 percent of their noninterest expenses on costs directly associated with complying with regulatory requirements. Thus, increased regulatory effort during the review process and the receipt of poor CAMEL ratings are costly to the bank and its managers, suggesting managers have incentives to take action to reduce regulatory attention. One of those actions could be to rely more on, or hire, a high quality auditor.

Regulators also have reasons to be concerned about their costs and, therefore, may look for opportunities to reduce costs (i.e., rely more on auditor output). First, government budget constraints discourage regulators from overrunning bank examination budgets without good cause. Deficit spending must be approved by lawmakers, which provides an incentive for government agents to control costs. Second, regulators are concerned with political costs. Poor performance or ineffective regulatory reviews can provide competing electoral candidates with an opportunity to attack the regulatory function. The economic consequences of a bank failure direct attention to the regulatory system. If the failed bank was given poor evaluations (i.e., high CAMEL ratings) prior to the bankruptcy, then the regulator is less likely to be blamed, and the regulatory system is less likely to come under attack, and is possibly praised as an effective warning device. On the other hand, regulators responding positively to the demands of p olitical constituents can garner public support and, therefore, enhance job security if the public believes their efforts prevent bank failure. In summary, regulators have incentives to be concerned about examination costs in light of how much regulatory attention is given to banks. Audit quality may provide a mechanism for bank examiners to reduce costs without decreasing the overall monitoring of bank condition.