In the intricate world of banking regulation, the role of external auditors has been a subject of debate. A study published in The Accounting Review by Sarah Stuber, assistant professor in the James Benjamin Department of Accounting at Mays Business School and colleagues, examines how the consequences of a regulatory change provide new insights into this dynamic. This study evaluates the impact of a change in the internal control audit mandate on bank regulator strictness and banking outcomes.

Context: The Regulatory Change

The study examines an amendment to the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in 2005. This amendment raised the threshold for requiring internal control audits from $500 million to $1 billion in assets, thereby exempting certain banks from the audit requirement. This scenario created an opportunity to assess how banks and regulators behave in the absence of third-party assurance from external auditors.

Research Approach

The researchers compared banks affected by this regulatory change to those that were never subject to the mandate. The study encompassed data from 2001 to 2010, and examines outcomes related to bank examinations, bank asset quality, and financial reporting.

Key Findings

1. Increased Reporting of Non-Performing Loans: Banks affected by the removal of the internal control audit mandate reported higher levels of nonaccrual loans. Given there is no evidence of deterioration in actual asset quality, the higher levels of reported nonaccrual loans indicate a shift towards stricter classification of loans by regulators in the absence of auditor internal control attestation.
2. More Troubled Debt Restructurings: Affected banks also reported a higher number of troubled debt restructurings (TDRs), suggesting a more conservative approach in loan classification.
3. Timelier Loan Loss Provisions: Loan loss provisions became timelier for affected banks, aligning with increased regulator effectiveness in monitoring.
4. Quality of Loan Loss Reserves: The findings are consistent with an improvement in the quality of the allowance for loan losses of affected banks.
5. Lengthier Targeted Examinations: Regulators spent more time conducting targeted examinations for banks impacted by the change, consistent with regulators increasing procedures over internal controls in the absence of external auditor assurance.

Implications and Insights

The study’s findings provide valuable insights into the banking regulation landscape:

1. Effectiveness of Direct Regulatory Monitoring: The results suggest that external assurance from auditors does not perfectly substitute for direct regulatory oversight. The increased scrutiny and stricter classification of troubled loans in the absence of auditor involvement demonstrate the critical role of direct regulator evaluation.
2. Balancing Regulatory Burden and Stability: The study highlights the trade-offs between reducing the regulatory burden on banks and ensuring the stability of the financial system. While the removal of the audit mandate reduced the external assurance burden for some banks, it also necessitated a more hands-on approach from regulators to maintain oversight.
3. No Evidence of Overly Strict Regulation: Importantly, the study does not find that regulators become overly strict. The improvement in the quality of loan loss reserves suggests a balanced approach to regulation, even in the absence of external audits.

Concluding Thoughts: A Shift in Oversight Dynamics

This study sheds light on a crucial aspect of banking regulation – the interplay between external audits and direct regulatory oversight. The findings suggest that regulators adjust their behavior and become stricter when third-party assurance over internal controls is removed. This adjustment helps maintain the oversight and discipline necessary for financial system stability, even in the absence of external assurance over internal controls.

In summary, the study underscores the importance of direct regulatory monitoring in the banking sector. It provides key insights for policymakers, regulators, and banking professionals, illuminating the dynamics of regulatory oversight and external assurance in a landscape that is continuously evolving.