The Impact of Credit Market Development on Auditor Choice: Evidence from Banking Deregulation

By | January 24, 2022

Understanding the forces that govern firms’ auditor choice decisions has long attracted attention from regulators, academics, and practitioners. High-quality auditors can provide greater assurance of the credibility of financial reporting. This improved assurance mitigates agency costs arising from adverse selection and moral hazard between firms and their capital providers, and in turn improves resource allocation and contracting efficiency in the economy. In our recent paper, we exploit the staggered adoption of the Riegle-Neal Interstate Banking and Branching Efficiency Act (IBBEA) across the U.S. as a source of plausible exogenous variation in the level of banking deregulation, investigating whether and how the infrastructure of the U.S. credit market shapes firms’ auditor-choice decisions.

Institutional background

The U.S. Congress enacted IBBEA in 1994, which allowed both unrestricted interstate banking (effective in 1995) and interstate branching (effective in 1997). During the period of 1994 to 2005, all fifty states passed state laws to relax interstate banking and branching restrictions. However, the interstate branching provisions contained in IBBEA also grant states the right to erect various types of roadblocks against out-of-state branch expansion.[i] The finance and economics literature shows that the relaxation of interstate branching restrictions facilitates banking competition, expands the creditsupply, lowers the cost of capital, and improves banking efficiency and profitability.

Empirical findings and channel analyses

Using a panel data set of 8,963 unique U.S. firms over our sample period of 1991 to 2008, we find that the relaxation of interstate branching restrictions negatively affects firms’ demand for high-quality auditors after controlling for a comprehensive set of factors that determine auditor choice. Compared with firms headquartered in states with the most restrictions on interstate branching, firms headquartered in states that are the most open to interstate branching are 4.8% less likely appoint a Big N auditor[ii] and 4.4% less likely to engage an industry specialist auditor.

In cross-sectional analyses, we find that the negative effect of banking deregulation on auditor choice is more pronounced for firms with greater external financing needs, high bank loan dependence, and small and young firms that are more likely to be financially constrained. Furthermore, we show that banking deregulation reduces demand for high-quality audits to a much greater extent in states with fewer sophisticated banks prior to deregulation and in states with more sophisticated entering-banks following deregulation. Finally, we also document evidence that the deregulation effect is stronger for firms with weaker corporate governance for which banks may play a significant role in monitoring managers’ behavior. These findings suggest that increased access to bank credit and banks’ strengthened monitoring of firms are the two underlying economic mechanisms through which banking deregulation manifests its impact on auditor choices.

Our contribution

Our study provides three key contributions. First, we provide novel evidence on the causal effect of credit market development, captured by banking deregulation, on firms’ auditor choice decisions. Our findings that banking deregulation reduces firms’ incentives to engage high-quality auditors imply that auditors play an important governance role when capital markets are less developed. This inference is consistent with the notion that auditors serve as a governance substitute for weaker institutions. Second, we add to the literature examining the effect of audits on debt financing and bank lending decisions. Our research complements these studies by providing evidence of the relation in the opposite direction—that debt-related factors affect the demand for audit services. Third, our study contributes to the literature examining the impact of banking deregulation on corporate policies and the economy. We expand this literature by showing that banking deregulation affects the audit market by inducing a lower propensity for firms to employ high quality audits.

Gus De Franco is the KPMG Professor of Accounting at the Freeman School of Business at Tulane University. 

Yuyan Guan is an Associate Professor at Nanyang Business School at Nanyang Technological University. 

Yibin Zhou is an Associate Professor at the Naveen Jindal School of Management at the University of Texas at Dallas. 

Xindong Zhu is an Associate Professor at City University of Hong Kong. 

This post is adapted from their paper, “The Impact of Credit Market Development on Auditor Choice: Evidence from Banking Deregulation” available on SSRN

[i] In particular, states can erect one or more of the four regulatory barriers: 1) mandating age restrictions on bank branches that can be purchased; 2) limiting the number of total deposits any one bank can hold; 3) forbidding out-of-state banks from opening new branches; or 4) forbidding out-of-state banks from acquiring existing branches.

[ii] Big N auditors refer to Big 6 auditors from 1991 to 1997, Big 5 auditors from 1998 to 2001, and Big 4 auditors since 2002.

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