The Role of Audit Firms in Spreading Depositor Contagion

Abstract

Auditor credibility is important in the banking industry due to the opacity of bank assets and the use of financial statements by external parties to facilitate monitoring. Depositors monitor and discipline bank behavior, but they can also contribute to the spread of shocks from one bank to another. We argue that depositors perceive bank failure as an audit failure, which reduces their assessment of auditor credibility. We document that exposure to failure through the audit firm is associated with lower uninsured deposit growth following the failure, consistent with depositors perceiving failures as a negative signal of auditor credibility. We further document that this association is stronger when depositors perceive connection to failure to reflect a pervasive issue within the audit firm. Collectively, our results suggest that depositors consider accounting signals at other banks in assessing financial reporting credibility.

Following the crowd? Peer influence on voluntary bank audits

“…4 We define % Peer Begin Audit imtÀ1 at the MSA (% Peer Begin Audit [MSA] mtÀ1 ) and state (% Peer Begin Audit [State] mtÀ1 ) levels based on bank headquarter location. 5 We define our primary measure 3 Consistent with prior literature, we assume the auditor of the bank holding company is also the auditor of the bank (Beck et al, 2022;Stuber & Hogan, 2021). In supplemental analyses, we limit our sample to single bank holding companies and our inferences remain unchanged.…”

“…Understanding peer influence on banks' audit decisions is important for two reasons. First, smaller community banks, many of which are exempt from audit mandates, are integral to local economies, and audits provide an important signal of financial reporting quality to key stakeholders of these banks (Beck et al, 2022; Lo, 2015; Rehm, 2012). Second, bank regulators rely on the work of auditors in performing regulatory exams, and prior research finds that variation in the extent of audit work affects regulatory oversight (Gopalan et al, 2023).…”

“…Finally, we examine whether the benefits of choosing to obtain an audit differ based on the extent of peer influence on the audit decision. We focus specifically on two factors shown in prior literature to be associated with a bank's audit status: interest costs and uninsured deposit levels (Badertscher et al, 2023; Beck et al, 2022; Doty, 2014; Lo, 2015; Minnis, 2011). We find no evidence that the potential interest rate savings or uninsured depositor gains of obtaining an audit vary with the extent of peer influence on a bank's audit decision.…”

“…We build upon literature that finds that stakeholders monitor bank audit decisions and audit quality by providing evidence that banks also monitor and consider the audit decisions of their peers when making decisions about whether or not to obtain an audit (Beck et al, 2022; Lo, 2015). This finding should be of interest to bank regulators as they consider the various factors that may affect bank audit decisions, particularly given the important role of financial reporting quality in banking system stability and the importance of audits to bank stakeholders (Acharya & Ryan, 2016; Beck et al, 2022; Lo, 2015). Recent regional banking crises and the associated concerns related to the quality of financial statements, particularly for community banks, further underscore the salience of the findings to regulators.…”