The Effect of Borrower Transparency on Bank Competition, Risk-taking and Bank Fragility

We show real effects in the banking sector that emanate from financial reporting transparency in the industrial sector. Prior research documents that transparency improves industrial firms’ access to arm’s-length financing via capital markets. We posit that this diminished reliance on banks increases competition in banks’ product markets, and forces them to offset their lost rents by (i) taking on more risk, and (ii) reducing their cost structures. Using mandatory adoption of International Financial Reporting Standards (IFRS) as identifying variation in borrower transparency, we find evidence of increased bank competition, greater bank risk-taking and higher cost efficiency. Additional tests suggest that risk-taking is channeled primarily through non-lending activities, pointing to the beneficial role of diversification in reducing bank fragility. We corroborate this beneficial role by documenting that borrower transparency correlates with higher bank stability (i.e., lower likelihood of a crisis). Overall, we provide novel evidence that financial reporting transparency in the industrial sector strengthens the banking sector. _______________________________ We appreciate helpful comments from Jerry Zimmerman (editor), an anonymous referee, Ashiq Ali, Anne Beatty, Andy Bernard, Jannis Bischof, Dane Christensen, Dan Collins, Bill Cready, Mark DeFond, Ken French, Andy Leone, DJ Nanda, Suresh Radhakrishnan, Shivaram Rajgopal, Bob Resutek, Sugata Roychowdhury, Cathy Schrand, K.R. Subramanyam, Xiaoli Tian, Regina Wittenberg-Moerman and workshop participants at Dartmouth (Tuck), Eight New York Fed/NYU Stern Conference on Financial Intermediation, Iowa, Nick Dopuch 2012 Accounting Conference, Ohio State, Penn State, Miami, UCLA, UC San Diego, USC and UT Dallas.