Publicly-Traded versus Privately-Held: Implications for Bank Profitability, Growth, Risk, and Accounting Conservatism

Transcription

1 ly-traded versus Privaely-Held: Implicaions for Bank Profiabiliy, Growh, Risk, and Accouning Conservaism D. Craig Nichols Assisan Professor of Accouning Johnson Graduae School of Managemen Cornell Universiy James M. Wahlen* Professor of Accouning Kelley School of Business Indiana Universiy 1309 Eas 10 h Sree Bloomingon, IN Mahew M. Wieland Assisan Professor of Accouning J. M. Tull School of Accouning Terry College of Business Adminisraion Universiy of Georgia Ocober 8, 2005 We graefully acknowledge helpful commens from D. Skinner, G. Udell, an anonymous referee, and workshop paricipans a he London Business School and he Universiy of Texas a Ausin. We also graefully acknowledge SNL Financial for providing daa. * Corresponding auhor.

2 ly-traded versus Privaely-Held: Implicaions for Bank Profiabiliy, Growh, Risk, and Accouning Conservaism Absrac ly-raded and privaely-held banks differ along dimensions of conrol srucure and capial marke access. We develop and es predicions abou he effecs ha hese differences have on banks profiabiliy, growh, risk, and financial reporing. Our empirical resuls are consisen wih our predicions. We predic and find ha public banks have lower profiabiliy bu faser growh in asses and conribued equiy capial han privae banks, afer conrolling for he choice o be public or privae, size, and differences in banks asses and liabiliies. Relaxing he conrol for size, we find larger banks are more profiable han smaller banks, consisen wih economies of scale in banking. Conrary o our predicions, we find ha public and privae banks do no differ on measures of risk relaed o earnings volailiy. and privae banks do differ wih regard o balance shee-based measures of risk, wih privae banks having more leverage and public banks mainaining higher regulaory capial raios. These resuls sugges public banks earn lower reurns per uni of risk han privae banks, bu achieve faser growh in asses and consequenly become more profiable hrough economies of scale. We predic and find resuls ha sugges ha sakeholders in public banks demand greaer degrees of accouning conservaism relaive o privae banks. For example, we find ha public banks recognize more imely earnings declines bu less imely earnings increases han privae banks. We also find ha public banks exhibi more conservaive accouning for loan losses. Loan loss provisions are larger and more imely, relaive o exogenous indicaors of probable credi losses, for public banks han for privae banks. Our resuls provide insighs for accouning and finance academics, as well as bank managers, audiors, and regulaors, abou he effecs of ownership srucure on bank profiabiliy, growh, risk, and accouning conservaism. The resuls highligh he implicaions of public and privae banks radeoffs of poenial agency coss associaed wih greaer separaion of ownership and conrol agains he benefis of capial marke access.

3 1. Inroducion ly-traded versus Privaely-Held: Implicaions for Bank Profiabiliy, Growh, Risk, and Accouning Conservaism How does he firm s equiy ownership srucure wheher common equiy shares are publiclyraded or privaely-held affec he firm s economic performance and financial reporing? This quesion is imporan because i addresses he fundamenal relaion beween organizaional form, organizaional performance, and financial reporing. We consider his quesion ineresing because, o dae, research provides lile insigh ino he effecs of ownership srucure on performance and financial reporing, in par because of he scarciy of readily-available accouning daa on privaely-held firms. This quesion is difficul o answer definiively because prior research provides lile guidance on he anecedens of he public/privae choice. Because hose anecedens are likely correlaed wih firm performance, researchers face a challenge in drawing unambiguous inferences regarding he effec of ownership srucure on performance and financial reporing. To address he quesion, his sudy provides empirical evidence on he relaion beween equiy ownership srucure, firm performance and financial reporing using accouning daa for a sample of publicly-raded and privaely-held U.S. commercial banks and bank holding companies (hereafer public and privae banks). 1 We examine and conrol for he degree of endogeneiy in his seing by esimaing a firs-sage selecion model o explain cross-secional variaion in he choice o be a public or privae bank wihin our sample. We hen develop and es predicions abou he effecs of equiy ownership srucure on differences in public versus privae banks profiabiliy, growh, risk, and accouning conservaism, while conrolling (a leas parially) for endogeneiy, size, and differences in banks asses and liabiliies. 2 1 Financial saemen daa are readily available for privae banks hrough regulaory filings. Two prior sudies exploi hese daa o examine earnings managemen across public and privae banks. Beay and Harris (1998) examine public and privae banks realizaions of securiies gains and losses o manage repored earnings in response o ax, agency cos, and informaion asymmery pressures. Beay, Ke and Peroni (2002) compare public and privae banks propensiies o avoid earnings declines by managing realizaions of securiies gains and losses and he discreionary componen of loan loss provisions. 2 In his AAA Presidenial Lecure, Endogenous Expecaions, Demski (2003) calls for more research o examine he naure of endogenously deermined variables, such as organizaional srucure and accouning informaion. 1

4 The choice o be a public bank raher han a privae bank riggers organizaional differences along wo imporan dimensions, conrol srucure and capial marke access, which have poenially counervailing implicaions for performance and financial reporing. Conrol srucure differences arise because greaer separaion exiss beween principal and agen (ownership and conrol) in a ypical public bank han a ypical privae bank. Greaer separaion beges he poenial for greaer degrees of informaion asymmery beween owners and managers of public banks han privae banks, which can exacerbae he poenial for moral hazard and adverse selecion problems. Raional principals and agens in public banks will herefore esablish more exensive and explici conracing and monioring mechanisms o align principals and agens incenives and enforce greaer muual accounabiliy in order o reduce exposure o agency problems. These conracing and monioring mechanisms are cosly. And despie heir inenions, such conracing and monioring are likely incomplee. Therefore, considering in isolaion he effecs of conrol srucure differences on agency coss, we predic public banks likely generae lower profiabiliy per uni of risk han privae banks, holding all else consan (e.g., he choice o be public or privae, size, and invesmen opporuniies). Conrol srucure differences canno be considered simply in isolaion due o he inheren poenial endogeneiy ha resuls from banks rading off he incremenal coss associaed wih increased agency problems agains he benefis from capial marke access. In paricular, capial marke access causes wo of he coss associaed wih equiy capial o be lower for public banks han for privae banks, all else equal. Firs, holding equiy capial is a more liquid invesmen for shareholders in a public bank han in a privae bank, so raional invesors demand a liquidiy premium o hold equiy in a privae bank, increasing he privae bank s cos of equiy capial (i.e., expeced rae of reurn on equiy). Second, a public bank can obain addiional equiy capial more efficienly han a privae bank because he public bank can raise new equiy capial direcly hrough capial marke ransacions (e.g., seasoned equiy offerings and sock-based acquisiions) wihou alering he public ownership saus of he firm. A privae bank also has hese equiy capial-raising opions, bu hey enail a fundamenal change in ownership srucure o become public, which is cosly. Thus, capial marke access enables public banks o face 2

5 lower coss of equiy capial and o raise new equiy capial more efficienly, which likely enables hem o generae faser raes of growh in asses and equiy. Growh in asses and equiy, and low coss of equiy capial, are criically imporan o banks because banking is essenially a low margin, high volume, high leverage business wih significan fixed operaing coss. Consequenly, economies of scale are imporan elemens of sraegy and compeiion in he banking indusry. We predic ha capial marke access enables public banks o generae faser growh in asses and equiy a lower coss of capial, and herefore ulimaely become larger, achieve greaer economies of scale, and generae greaer profi per uni of risk han privae banks, holding all else equal (e.g., he choice o be public or privae, size, and invesmen opporuniies). The public-privae ownership choice is also likely o endogenously deermine sakeholders demands for conservaive accouning. Chrisensen and Demski (2003) argue ha exernal verifiabiliy is he comparaive advanage of accouning as a source of informaion relaive o oher informaion sources. As separaion of ownership and conrol increases, so does he demand for exernal verifiabiliy of managers financial repors. Therefore, he demand for verifiable accouning informaion will likely differ across firms based on he degree of separaion beween ownership and conrol of resources. The demand for verifiabiliy also depends on he naure of he accouning informaion. Conservaism can be viewed as a lower verifiabiliy hreshold for bad news han for good news (Basu 1997). Was (2004) argues ha accouning conservaism survives in equilibrium because i consrains managers opimism. The need o consrain managemen opimism in financial reporing is likely increasing in he poenial for informaion asymmery o creae agency problems, so he demand for accouning conservaism is likely greaer among public firms han privae firms. We herefore make wo predicions wih respec o differences in accouning conservaism across public and privae banks. Firs, exending Ball and Shivakumar (2005), we predic public banks recognize more imely earnings decreases and less imely earnings increases han privae banks, all else equal. Second, we predic ha public banks exhibi more conservaism in accouning for loan losses han privae banks, all else equal. We predic ha public banks recognize larger 3

6 and more imely loan loss provisions (relaive o changes in non-performing loans, which are nondiscreionary indicaors of changing credi qualiy) in earnings han privae banks. Our empirical ess invesigae differences in profiabiliy, growh, risk, and accouning conservaism across public and privae banks in order o infer he effecs of he radeoffs beween conrol srucure and capial marke access. All of our empirical ess conrol for he probabiliy he bank is public or privae given our firs-sage selecion model, as well as oher poenially confounding facors such as size and difference in ypes of asses, loans ousanding, and liabiliies. We examine accouning-based measures of profi, growh, risk, and conservaism because of he absence of marke-based measures for privae banks. Our sample consiss of 1,652 privae banks (10,283 bank-years) and 608 public banks (4,058 bank-years) during 1992 o 2002, including all banks for which we can obain daa wih oal asses ha fall wihin he range beween he smalles public bank and he larges privae bank. In he firs-sage of our empirical analysis, we find significan differences across public and privae banks and across bank-size in ypes of invesmens and financing. Using hese resuls, we develop and esimae a probi selecion model o esimae he likelihood a given bank is public or privae, condiional on he bank s proporions and ypes of asses (differen ypes of loans ousanding, cash and invesmen securiies, and inangibles); he proporions and ypes of financing (e.g., deposis, long erm deb, and preferred sock); as well as characerisics such as size, profiabiliy, and growh. Our selecion model explains 50 percen of he cross-secional variaion in he choice o be a public or privae bank wihin our sample. Following Ball and Shivakumar (2005), we hen implemen he Heckman (1979) wosage approach, using he parameers from he firs-sage selecion model o compue inverse Mills raios for each firm in he sample. In each of our ess in he second sage, we include he inverse Mills raio and allow is coefficien o vary beween public and privae banks as a (parial) conrol for he likelihood each bank will choose o be public or privae. Consisen wih our predicion for he effecs of conrol srucure, our resuls indicae ha public banks are less profiable per uni risk han privae banks, afer conrolling for he public-privae choice, size, and banks asses and liabiliies. We find ha public banks generae lower profi margins, lower 4

7 reurns on asses, and lower reurns on common equiy han privae banks of equivalen size and wih a similar mix of asses and liabiliies. Consisen wih our predicion for he effecs of capial marke access, we find ha public banks generae faser raes of growh in asses and equiy from conribued capial han privae banks. However, we also find ha privae banks generae faser raes of growh in inernally generaed equiy capial, by earning higher raes of reurn on common equiy and mainaining higher earnings reinvesmen raes (i.e., lower dividend payou raios). We also find srong evidence of economies of scale in banking conrolling for public versus privae ownership, larger banks generae greaer profiabiliy and faser growh in earnings han smaller banks. Wih respec o risk, and conrary o our predicions, we find no significan differences in imeseries volailiy in reurn on asses and reurn on common equiy across public and privae banks, afer conrolling for he public-privae choice, size, and differences in banks asses and liabiliies. Also conrary o our expecaions, we find ha public and privae banks do have differen balance-shee-based measures of risk, wih privae banks having greaer degrees of leverage and public banks mainaining lower regulaory capial raios. From he resuls on profiabiliy, growh, and risk, we conclude ha, consisen wih our predicions, public banks generae less profiabiliy per uni of risk han privae banks of equivalen size. However, relaxing he conrol for size, public banks enjoy faser growh, become larger, achieve greaer economies of scale, and herefore generae greaer profiabiliy han privae banks. These resuls imply ha he coss associaed wih agency problems dominae he benefis of capial marke access for public banks relaive o privae banks of equal size, bu capial marke access enables public banks o become larger and capure greaer profiabiliy from economies of scale. These implicaions may be parial explanaions for why we observe (a) he majoriy of banks ha seemingly mee U.S. sock exchange lising requiremens choose o remain privaely-held, bu (b) he larges and mos profiable banks in he U.S. are publicly-raded. Wih respec o implicaions of ownership srucure for financial reporing, wo relaed ses of ess provide evidence consisen wih our predicions ha ownership srucure differences rigger greaer demand for accouning conservaism among public banks han privae banks, afer conrolling for he 5

8 public-privae choice, size, and ypes of loans ousanding. Firs, we exend he approach in Ball and Shivakumar (2005) o predic and find ha public banks recognize more imely decreases in earnings and less imely increases in earnings han privae banks. Second, we predic and find greaer conservaism in loan loss accouning among public banks han privae banks. We predic and find ha public banks recognize larger and more imely loan loss provisions wih respec o changes in nonperforming loans han privae banks. This paper conribues new evidence on he radeoffs beween coss associaed wih agency problems and benefis associaed wih capial marke access by predicing and finding fundamenal differences in profiabiliy, growh, risk, and accouning conservaism across public and privae banks. Our findings should be of ineres o scholars in accouning, finance, and banking concerned wih he endogenous ineracions beween ownership srucure, performance, and financial reporing. Our resuls should also be useful for bank managers, audiors, and regulaors. We organize he remainder of he paper as follows. In he nex secion, we describe he implicaions of public versus privae ownership for bank performance, growh, risk, and financial reporing, and we address regulaory, ax, and endogeneiy issues. In he hird secion, we describe he sample selecion procedures and our sample daa. In secion four, we presen our ess and resuls. We conclude in secion five. 2. Implicaions of public versus privae ownership Like oher firms, banks ha mee he lising requiremens esablished by a U.S. sock exchange 3 can choose o have heir equiy shares lised publicly on he exchange and raded among invesors, or hey can choose o forego public lising and reain privae ownership of equiy claims. We presume ha a bank s shareholders are raional and herefore heir elecion for he bank s shares o be publicly-raded or privaely-held is opimal, in ligh of heir objecive funcions and risk-reurn preferences. In his paper we 3 For example, he mos sringen lising requiremens are hose of he NYSE, which requires firms o have a minimum size of $60 million in marke value, and 500 invesors in order o lis. Firms mus mainain a leas $15 million in marke capializaion o remain lised on NYSE. 6

9 do no address he full array of coss and benefis in his choice. Insead, our objecive is o predic and es some (bu no all) of he observable implicaions of he decision o be a public versus a privae bank. In his secion, we firs describe differences beween public and privae banks along wo criical dimensions, conrol srucure and capial marke access, which have poenially imporan implicaions for profiabiliy, growh, and risk. We hen describe he implicaions of public versus privae ownership for banks financial reporing, firs focusing on differences in accouning conservaism in earnings in general, and hen focusing on accouning conservaism in loan loss provisions in paricular. In he final subsecion, we address regulaory, ax, and endogeneiy issues in his research seing. 2.1 Conrol srucure implicaions Greaer separaion beween principals and agens exiss for a public bank han a similar privae bank, implying differences in he banks conrol srucures. Privae banks are more likely o be closelyheld among smaller numbers of shareholders, wih owner-managers more likely o be majoriy equiy sakeholders. banks are likely o have more dispersed equiy ownership among greaer numbers of shareholders, wih owner-managers more likely o be minoriy equiy sakeholders. Thus, more separaion beween shareholders and managers is likely o exis wihin a public bank han a privae bank. Greaer separaion beween principal and agen creaes greaer poenial for informaion asymmery, which implies greaer poenial for moral hazard and adverse selecion problems (Jensen and Meckling, 1976). Wih relaively lile separaion (or in some cases no separaion) beween owners and managers of privae banks, principals can more easily monior he acions of he managers, more easily obain managers privae informaion, and are more likely o have incenives ha closely align wih (or are idenical o) hose of he managers. If privae bank managers are likely o be proporionally larger shareholders in heir banks han are public bank managers, hen privae bank managers will be less likely o exploi informaion asymmery o shirk, consume excessive perquisies and compensaion, and ake excessive risk, because hey bear a greaer proporion of he coss of hese acions han public bank managers. The poenial for moral hazard and adverse selecion problems is more acue among public 7

10 banks insofar as greaer separaion beween ownership and conrol creaes greaer degrees of informaion asymmery and greaer divergence in incenives. The poenial for informaion asymmery, and is concomian poenial for moral hazard and adverse selecion, arises wihin banks because banks inermediae many ypes of risk in he marke for capial credi risk, ineres rae risk, pre-paymen risk, exchange rae risk, liquidiy risk, and ohers. All of hese risks depend o some degree on sysemaic movemens in marke prices (e.g., ineres raes and exchange raes); however, a bank s exposure o hese risks is no easily observable o exernal sakeholders. In paricular, exposure o credi risk is leas easily observable by ousiders, and i has he mos idiosyncraic naure of all of hose risk-ypes. Therefore, credi risk creaes he greaes poenial for informaion asymmery and relaed agency problems. A bank s loan pricing and credi-risk-managemen aciviies depend on he bank s collecion and evaluaion of privae informaion abou borrowers credi qualiy across large porfolios of loans. In he case of public banks, managers are likely o have subsanial privae informaion abou loan porfolio credi qualiy and credi risk ha exernal shareholders do no have. This can enable public bank managers o pursue privae gains (e.g., hrough aggressive loan porfolio growh, opporunisic underwriing, or sraegic iming of rades of he bank s sock on privae accoun) wihou shareholders being fully informed (paricularly if conracing and monioring beween shareholders and managers is incomplee). 4 Among privae banks, wih less separaion beween owners and managers and herefore less informaion asymmery, managers likely have less poenial and less incenive o exploi heir privae informaion abou loan porfolio credi qualiy in order o creae privae gains. These poenial agency problems, if realized, will resul in lower profiabiliy per uni of risk among public banks han privae banks. Raional principals and agens undersand ha he coss of poenial moral hazard and adverse selecion problems can be subsanial, paricularly wih respec o credi risk. Principals and agens herefore demand increased muual accounabiliy hrough more exensive (and cosly) conracing and 4 The hrif crisis of he 1980s and episodic bank failures (e.g., Barings Bank in he early 1990s) serve as painful reminders of he cosly naure of hese ypes of moral hazard and adverse selecion problems. 8

11 monioring mechanisms designed o miigae such agency problems. For example, public banks may rely more heavily on explici pre-commimen beween shareholders and managers o muually accepable credi risk-aking and loan porfolio growh sraegies, more layers of credi risk approval and review, more risk averse credi risk-pricing, along wih appropriae compensaion schemes, reporing, and corporae governance arrangemens designed o align shareholder and manager preferences for profiabiliy, growh, and risk. Insofar as conracing and monioring mechanisms creae addiional coss, hey could resul in lower profiabiliy per uni risk among public banks han oherwise equivalen privae banks. Furher, even a well-designed monioring and conrol srucure will be incomplee, and he public bank will sill be exposed o some degree of agency coss. Thus, he choice o be a public or privae bank involves a choice abou he preferred level of exposure o poenial agency problems, and he conracing coss associaed wih miigaing such poenial problems. We predic ha, afer conrolling for bank size and he likelihood a given bank is public or privae, agency coss likely resul in lower profiabiliy per uni of risk for public banks han privae banks, ceeris paribus. We nex consider he relaive benefis o public banks wih access o public capial markes. 2.2 Capial marke access implicaions Choosing o be a public or privae bank is endogenously deermined wih he choices regarding fuure access o he equiy capial marke, which in urn imply differences in he cos of equiy capial (e.g., he required rae of reurn o equiy shareholders) as well as he ransacions coss involved in fuure equiy capial placemens. Wih regard o he cos of equiy capial, we assume ha holding equiy capial in a public bank is a more liquid invesmen for shareholders han is holding equiy capial in a privae bank, because equiy shares of public banks can be raded wih relaively low ransacions coss in he capial marke. 5 We herefore assume invesors demand a liquidiy premium o hold privae bank equiy. Thus, holding all else consan mos noably, holding consan all oher risks and he agency problems of he previous secion public banks will enjoy a lower cos of equiy capial han privae banks. 5 If a privae bank elecs S-corp saus for ax purposes, i can make he equiy shares even less liquid due o ax law consrains. 9

12 Capial marke access also permis public banks o raise addiional equiy capial hrough seasoned equiy offerings and sock issues in acquisiions wihou a fundamenal change in he ownership srucure of he firm. These equiy capial-raising opions are also available o privae banks, bu hey require he privae bank o go public, which is cosly. Furher, he owner-managers of a privae bank have presumably srucured heir invesmens in he bank (and he res of he wealh in heir personal porfolios) o mach heir desired risk-reurn preferences. Becoming a publicly-raded bank can aler exising owner-managers exposures o bank-specific risks, eiher by requiring hem o make addiional capial invesmens in he bank (increasing heir risk exposures above a level hey perceive o be opimal) or by obaining addiional capial from new equiy claimans (diluing exising owner-managers claims and conrol over he bank s risks and reurns o a level below wha hey perceive o be opimal). Lower coss of equiy capial and more efficien access o addiional sources of equiy capial a lower ransacions coss should enable public banks greaer abiliy o fund asse growh and make acquisiions. Banking is a low-margin, high-volume, high leverage business, wih significan fixed operaing coss (e.g., branch locaions, back-office infrasrucure, informaion and ransacion processing sysems), creaing poenial economies of scale in he banking indusry. Capial marke access should enable public banks o raise equiy capial o grow asses more quickly and efficienly, realize greaer economies of scale, and herefore enjoy greaer profiabiliy per uni of risk han privae banks. Capial marke access also suggess public banks have addiional degrees of freedom o issue equiy capial when necessary o mee regulaory capial requiremens following an unexpeced equiy capial shorfall. 6 This should enable public banks o operae in equilibrium wih lower relaive levels of equiy capial, and inves in projecs ha are more risky (e.g., more volaile wih respec o fuure earnings and equiy capial), han comparable privae banks. The benefis of capial marke access appear o be numerous and subsanial, enabling public banks o grow more quickly, be more acive in acquisiions, 6 Federal bank regulaors require ha banks mee cerain minimum capial adequacy raios. We describe hese requiremens and heir implicaions for his sudy in a following secion of he paper. 10

13 generae more significan economies of scale, use greaer degrees of leverage, absorb greaer earnings volailiy, and ye face lower coss of equiy capial han privae banks. On he one hand, we predic ha, in isolaion, he conrol srucure implicaions idenified in he prior secion are likely o make a public bank less profiable per uni risk han an idenical privae bank. On he oher hand, in his secion we predic ha capial marke access should enable a public bank o raise equiy capial wih lower associaed coss, finance more rapid growh, and ulimaely realize greaer benefis from economies of scale. Ulimaely, we seek o shed empirical ligh on he radeoffs beween conrol srucure implicaions and capial marke access implicaions across public and privae banks. Our empirical ess compare dimensions of profiabiliy, growh, and risk across public and privae banks, while conrolling for he public-privae bank choice, size, and differences in asses and liabiliies. In he nex secion, we describe our predicions for he implicaions of public versus privae ownership on banks financial reporing. 2.3 Implicaions for financial reporing Conservaism in repored earnings Chrisensen and Demski (2003, p.338) argue ha exernal verifiabiliy is he comparaive advanage of accouning as a source of informaion relaive o oher informaion sources. Verifiabiliy consrains managers financial reporing in ha i limis wha informaion can ener he accouning sysem, helping o ensure ha he informaion in he accouning sysem is reliable. Generally acceped accouning principles (GAAP) provide srucure for verifiabiliy consrains and hresholds for specific accouning issues. Indeed, many of he curren conroversies abou accouning principles involve verifiabiliy (e.g., esimaing fair values for sock opion grans and financial insrumens, and esing inangible asses for impairmens). When a firm implemens GAAP, verifiabiliy is parly he resul of implemenaion of GAAP guidance and parly he resul of negoiaed policy beween agens (firm managers), principals (equiy shareholders and crediors), and inermediaries (such as audiors and regulaors). Therefore, he demand for verifiabiliy wihin GAAP will vary across firms and is endogenously deermined wih he degree of 11

14 separaion beween ownership and conrol of resources (e.g., beween public and privae ownership). As separaion of ownership and conrol increases, so does he demand for exernal verifiabiliy of managers financial reporing. The demand for verifiabiliy in financial reporing also depends on he naure of he informaion. Conservaism imposes a lower verifiabiliy hreshold for bad news and a higher hreshold for good news (Basu 1997). Was (2004) conjecures ha accouning conservaism survives in equilibrium because i acs as a counerweigh o balance managers opimism bias, paricularly in he conex of uncerainy and informaion asymmery from he separaion of ownership and conrol. Thus, he need o consrain managers opimism bias in financial reporing is likely also increasing in he poenial for informaion asymmery o creae agency problems, so he demand for accouning conservaism is likely greaer among public firms han privae firms, and is likely greaer for good news han bad news. The demand for verifiabiliy and conservaism is paricularly acue among banks because, as discussed earlier, banks involve a poenially high degree of informaion asymmery regarding risk exposures (credi risk, ineres rae risk, ec.) Thus, we predic ha public banks will exhibi a greaer degree of conservaism in financial reporing han privae banks. Specifically, we predic ha recogniion of bad news in earnings (e.g., earnings declines) will be more imely, and recogniion of good news in earnings (e.g., earnings increases) will be less imely for public banks han for privae banks. In making hese predicions, we assume ha he informaion ses available o managers, and he imeliness of he arrival of new informaion o managers, are comparable across public and privae banks. We do no argue ha public and privae banks are idenical excep for form of ownership; insead, we argue ha hey are reliably comparable insofar as hey engage similar producion funcions, inves in similar asses, ake similar risks, compee wih similar business models, and are affeced by common economic evens. Thus, we conrol for he likelihood a given bank will choose o be public or privae, and for differences in observable characerisics (e.g., size, ypes of loans ousanding, ec.), and isolae wheher ownership 12

15 differences manifes in more imely reporing of earnings decreases and less imely reporing of earnings increases among public banks han privae banks Conservaism in loan loss recogniion Accouning for he consequences of a bank s exposure o loan porfolio credi risk requires judgmen and esimaion. Loan loss provisions are bank managers accruals for changes in heir expecaions of fuure uncollecible loans. Loan loss provisions reflec managers judgmen and esimaion of changes in he expeced fuure losses aribuable o credi risk in he loan porfolio. The loan loss provision is an expense ha reduces repored ne income, and reduces he ne asse accoun for he loan porfolio (by increasing he conra-asse loan loss allowance accoun) on he bank s balance shee. Because of he high degree of informaion asymmery inheren in banks exposures o credi risk and he discreionary naure of loan loss provisions, he SEC requires banks o disclose various pieces of credi-risk-relaed informaion, including he amoun of non-performing loans. Banks ypically classify a loan as nonperforming when i is a leas 90 days overdue on ineres and/or principal paymens. Thus, he nonperforming loans amoun is a relaively nondiscreionary leading indicaor of loan qualiy. 8 A bank will recognize a loan chargeoff when i deems a porion or all of a loan uncollecible. Chargeoffs require accouning discreion o esimae he amoun and iming of he uncollecible porion of a loan. Various 7 Ball and Shivakumar (2005) examine accouning qualiy differences across samples of public and privae (nonfinancial) firms in he U.K. They porray imely recogniion of losses as one imporan (bu no he only) characerisic of accouning qualiy. They predic and find ha public firms recognize more imely losses in earnings han privae firms. We make he same predicion, bu furher predic ha public firms recognize less imely good news in earnings. We also refine he analysis by examining specific iming of loan loss recogniion across public and privae banks. 8 Alhough nonperforming loans are relaively nondiscreionary, bank managers do have a leas wo forms of discreion over disclosed levels of nonperforming loans. Firs, hey can choose o make new loans o disressed borrowers o enable hem o keep heir exising loans performing (reporedly a common pracice among U.S. banks o delay recogniion of nonperforming loans o developing counries from he 1970s unil 1987). Second, hey can elec o chargeoff loans ha are nonperforming, hereby removing he loan balances from he loan porfolio asse accoun on he balance shee and from he disclosed level of nonperforming loans. Obviously, boh of hese seps can be cosly o banks, so we deem nonperforming loans o be relaively nondiscreionary. 13

16 facors rigger chargeoffs, including loan-specific judgmens, bank policy (e.g., all loans ha exceed some hreshold of delinquency), and exernal evens (e.g., a borrower s declaraion of bankrupcy). 9 From he perspecive of imeliness of recogniion, bank managers disclose loans as nonperforming once he loans exceed 90 days of delinquency. Bank managers record loan loss provisions o recognize heir expecaions for fuure loan losses in income and on he balance shee. Bank managers hen recognize loan chargeoffs upon realizaions of loan losses. Thus, loan loss provisions deermine he imeliness wih which banks recognize loan loss expecaions in income and on he balance shee. Banks wih more conservaive loan loss accouning will recognize provisions ha are larger and furher in advance or concurren wih when loans deeriorae o non-performing saus. Banks wih less conservaive loan loss accouning will recognize smaller and less imely loan loss provisions, subsequen o loans reaching non-performing saus. Refining our prior argumens abou conservaism wih respec o earnings, we predic ha public banks will recognize larger and more imely loan loss provisions relaive o changes in nonperforming loans han privae banks Regulaory, ax, and endogeneiy issues Federal and sae bank regulaors monior and impose resricions on banks in order o enhance he safey and soundness of he banking sysem for deposiors and o reduce he risk and cos borne by he Federal Deposi Insurance Corporaion (FDIC). Bank regulaors examine (i.e., audi) each bank roughly once a year. Bank examinaions can lead regulaors o require banks o recognize larger or more imely loan loss provisions, and/or chargeoffs for cerain loans he regulaors deem uncollecible. In addiion, under he risk-based capial adequacy requiremens adoped in 1990, each bank mus mee cerain 9 Banks recognize loan chargeoffs by wriing down he ousanding balance in loans receivable and he loan loss allowance by he uncollecible amoun of he loan. Thus, a loan chargeoff has no ne effec on oal asses or shareholders equiy. Banks disclose loan chargeoffs in foonoes o he financial saemens. 10 Ideally, we would also like o predic ha public banks wih more conservaive loan loss accouning will recognize more imely loan loss provisions furher in advance of relaed loan chargeoffs. As noed above, however, he iming and amouns of loan chargeoffs are also somewha discreionary. banks may exhibi greaer accouning conservaism by recognizing more imely provisions and chargeoffs han privae banks, confounding our abiliy o isolae public versus privae differences in he imeliness of provisions relaive o chargeoffs. Therefore, we make no predicions abou differences in imeliness of provisions relaive o chargeoffs. 14

17 minimum capial adequacy raios. 11 These requiremens impose limis on bank leverage, and hereby consrain bank growh and risk-aking. Banks ha fail o mee hese capial requiremens can be subjec o significan regulaory consrains (such as limis on dividends or acquisiion aciviy), and banks deemed severely under-capialized can be subjec o regulaory closure. Through examinaions and capial requiremens, regulaors provide bank owners (and deposiors) wih monioring mechanisms ha reduce agency coss and provide exernal verifiabiliy of accouning informaion. Regulaors impose he same examinaion and capial requiremens on public and privae banks alike for he proecion of deposiors and he FDIC, so regulaory capial requiremens are no likely o bias our analysis in favor of finding differences beween public and privae banks. To he conrary, bank regulaory pressures ha lead o conservaive loss recogniion by public and privae banks will reduce he power of our ess o deec differences in accouning conservaism. 12 Banks wih less han $500 million in oal asses have ax incenives o recognize conservaive loan loss provisions because hey receive a ax deducion for he loan loss provision, whereas banks wih more han $500 million in asses mus deduc heir loan losses on a cash basis (loan chargeoffs). In our empirical analyses, we conrol for size-differences across banks, which should miigae he effecs of ax incenives on our resuls. 13 We also examine profiabiliy before and afer ax effecs, o verify ha our resuls are no being driven by differences in income axaion. As noed a he ouse, he choice o be a public or privae bank is likely o be endogenously deermined o some degree wih he bank s profiabiliy, growh, risk and accouning conservaism 11 Federal bank regulaors require ha each bank mainain a Tier 1 Capial Raio of 10% (6%) or beer o be considered well-capialized (adequaely-capialized). The Tier 1 capial raio is roughly equal o common shareholders equiy over oal asses. In addiion, each bank mus have a Risk-Based Capial Raio of 6% (4%) or beer o be considered well-capialized (adequaely-capialized). The risk-based capial raio is roughly equal o common shareholders equiy over risk adjused asses, in which low risk asses such as cash receive very low weigh, and risky asses such as loans receive full weigh. 12 The exisence of Federal subsidized deposi insurance for banks creaes a poenial moral hazard problem beween regulaors (as principals represening deposiors) and bank owners and managers (as agens enrused wih deposiors capial). Boh public and privae banks have incenives o avoid or delay recognizing losses o remain adequaely capialized and mainain access o subsidized Federal deposi insurance. These incenives could bias our ess agains finding conservaism, bu hey should no bias our ess of differences in accouning conservaism across public and privae banks. 13 Cloyd, Pra, and Sock (1996) conduc a survey-based experimen and find ha privae bank managers are more likely han public bank managers o manage earnings down in order o reduce axable income. 15

18 characerisics. Endogeneiy arises because i is likely ha a bank s expeced invesmen opporuniies and consrains and ambiions for fuure growh and profiabiliy likely influence is choice o be public or privae, which in urn are deerminans ha influence he bank s abiliy o generae growh and profiabiliy. In designing his research, we choose o esimae and conrol (o he bes of our abiliy) for he likelihood a given bank will be public or privae, as a predeermined choice. Given his conrol (and i is of course impossible o conrol perfecly for all of he implicaions associaed wih fundamenal characerisics such as ownership srucure), we hen seek o isolae he subsequen consequences of being public or privae on banks profiabiliy, growh, risk, and financial reporing, based on our predicions abou differences in conrol srucure and capial marke access. Thus, we ake a direcional ack wih he poenially endogenously deermined variables in his seing. The direcional effecs of endogeneiy in his seing could be opposie o our predicions and confound our ess. For example, if banks wih unusually high profiabiliy per uni of risk are mos likely o become public, and if his effec dominaes he agency coss embedded in being a public bank, hen his is conrary o our predicions ha agency problems wihin public banks reduce bank profiabiliy per uni of risk. Likewise, capial marke access is advanageous o a public bank primarily if he capial markes assign a fair price o he bank s shares. Does he need o mee earnings expecaions in he capial markes, or managers opporunism o enhance personal wealh, drive public banks o more aggressive (less imely) recogniion of earnings and less conservaive recogniion of loan loss provisions? This is also conrary o our predicions. Ulimaely, our empirical evidence should shed some ligh on wheher hese possible direcional effecs of endogeneiy dominae our predicions. We urn nex o he sample selecion and daa, and hen o our ess and resuls. 3. Sample selecion and descripive saisics 3.1 Sample selecion We obain bank holding company and commercial bank daa from release 5.0 of he SNL Regulaory Daasource (SNL) daabase supplied by SNL Financial. The daabase provides regulaory 16

19 daa on public and privae banks from 1990 o We rely on SNL s public ownership classificaion o idenify bank ownership srucure. SNL classifies banks as privae or public based on wheher he company files financial saemens wih he Securiies Exchange Commission. Our use of SNL daa creaes several issues relaed o our sample of banks. Firs, when a bank convers from one ype o anoher (privae o public, for example), SNL reclassifies he bank s enire pas regulaory daa in subsequen versions of SNL under he laes ownership srucure. Thus, a privae bank ha goes public in 1999 will appear o be public in he years prior o SNL does no rack changes in bank ownership srucure so we assume ha a bank s curren ownership srucure represens he enire sample period. Classificaion errors creae noise ha bias agains our ess of differences across public and privae banks. Second, SNL racks banks ha have merged, been acquired, or failed, in a separae daabase of acquired/defunc banks. When a bank acquires or merges wih anoher bank, SNL assigns he acquiring banks corporae informaion o all prior regulaory daa of he acquired bank. We canno deermine wheher he daa in he acquired/defunc daabase relae o a public or privae bank, or o a subsidiary of anoher bank. Thus, our sample only consiss of acive banks ha have no been acquired in prior years. As a parial conrol for size, we creae a censored sample of privae and public banks each year wihin a common size range by eliminaing public banks wih oal asses larger han he larges privae bank and eliminaing privae banks wih oal asses smaller han he smalles public bank. This eliminaes 15,311 firm-year observaions. Furher, we include size as a predicion variable in our firs-sage probi selecion model and as a conrol variable in each of our es regressions. In addiion, as a parial conrol for ouliers, we sudy a runcaed sample ha excludes he observaions in he op and boom percenile of each annual cross-secion of earnings changes (similar o Ball and Shivakumar 2005) and loan loss provisions. Afer hese sample resricions and exclusions, and afer requiring firms o have necessary daa for our analyses, he sample consiss of 1,652 (608) privae (public) banks, wih 10,283 (4,058) bankyears covering 1992 o For hese banks, SNL provides only limied daa on heir equiy ownership srucures. SNL only has shareholder daa for 332 of he public banks in our sample for 2002, he final year of our sudy. In ha 17

20 year, his subsample of public banks had an average of 2,026 shareholders and a minimum of 90 shareholders. The SNL daabase conains no shareholder daa for privae banks, prevening a direc comparison wih public banks. However, he SNL daabase does provide axpayer saus daa for privae banks. Among he 1,371 privae banks in our sample wih available axpayer saus daa in 2002, 36.1 percen eleced S corporaion saus, which allows a maximum of only 75 shareholders. These daa suppor our asserions ha privae banks are more likely o be closely-held among smaller numbers of shareholders, and public banks are likely o have more dispersed equiy ownership among greaer numbers of shareholders. Thus, greaer separaion beween shareholders and managers likely exiss wihin a public bank han a privae bank. 3.2 Descripive saisics Table 1 presens descripive saisics for public and privae banks, wo-sample Wilcoxon ranksum ess, and -saisics for differences across hese wo groups. Table 2 presens correlaion saisics for he variables in our regression analyses. The descripive saisics in Table 1 sugges our sample banks span a wide cross-secional disribuion of oal asses. The saisics in Table 1 also describe some of he differences beween sample public and privae banks. Despie censoring our sample o a common size range, wihin our sample oal asses for he average public bank are almos four imes larger han for he average privae bank. The average public bank grows faser, is less leveraged, generaes greaer reurns on equiy and asses, and has larger proporions of asses in family loans, commercial real esae loans, and commercial loans, and larger invesmens in goodwill and inangibles. Privae banks end o have larger proporions of asses invesed in cash, securiies and agriculural loans. On average, public banks also mainain lower levels of ier-one capial and oal risk-based capial, a possible resul of having he abiliy o access low-cos opions o boos equiy capial when necessary o mee regulaory capial requiremens. Table 2 deails univariae correlaions among he variables in his sudy ha relae o bank ownership srucure, profiabiliy, risk, growh, and accouning conservaism. In Panel A, he correlaions beween Dpub (an indicaor variable we se equal o one for publicly-raded banks and zero for privaely- 18

21 held banks) and our measures of profiabiliy, growh, and risk provide similar picures as he ess of mean differences in Table 1. Panel B provides correlaions for he variables we use o analyze earnings changes. The correlaions in Panel B sugges public banks experience larger earnings changes in he curren and prior periods and less negaive earnings changes in prior periods. Panel C provides correlaions for variables we use in our analysis of loan loss provisions. Loan loss provisions correlae srongly wih changes in non-performing loans, and hese correlaions appear o differ beween public and privae banks. 3.3 Selecion model for public versus privae ownership As discussed earlier, banks likely selec public or privae ownership saus based on expeced (or desired) fuure changes in profiabiliy and growh, and so ownership saus and profiabiliy, growh, risk, and conservaism may be endogenously deermined o some degree. 14 To conrol for poenial bias resuling from endogeneiy in ownership saus and our profiabiliy, growh, risk, and conservaism measures, we follow Ball and Shivakumar (2005) by using he Heckman (1979) wo-sage approach. In he firs sage, we model he selecion of public versus privae ownership saus by esimaing a probi selecion model, using predicor variables ha capure various observable characerisics relaed o ownership saus selecion. We hen use he parameers from he probi selecion model o compue an inverse Mills raio for each sample bank. In he second sage, we esimae all of our regressions o es he effecs of ownership saus on profiabiliy, growh, risk, and conservaism by including he inverse Mills raio as a conrol for he likelihood a bank is public or privae, and we allow is coefficien o vary beween public and privae banks. The univariae descripive saisics in Table 1 reveal ha public and privae banks have significanly differen invesmen opporuniies and financial capial sraegies. We rely on differences across public and privae banks invesmens and financing o idenify predicor variables ha explain 14 In heory, one could argue ha he choice o be public or privae is a coninuous choice (i.e., banks always have he opion o change ownership saus a any poin in ime) and herefore ownership saus and profiabiliy, growh, risk, and conservaism are simulaneously deermined. We believe, and he daa sugges, ha banks do no change ownership saus frequenly, so we rea ownership saus as a predeermined correlaed variable ha influences banks subsequen profiabiliy, growh, risk, and conservaism, raher han as a simulaneously deermined variable. 19

22 banks selecion of public or privae ownership. To idenify hese differences, and o aribue such differences o ownership saus and no bank size, we esimae a series of regressions in which we regress common-size balance shee componens on Dpub while conrolling for size, measured as he cenile rank of he bank s oal asses wihin our cross-secional sample a he end of each year. Each regression akes he following general form: Dependen Variable = φ Dpub Size + ε (1) We presen he resuls of hese regressions in Table 3. Consisen wih he univariae descripive saisics in Table 1, hese regressions reveal ha a number of common-size balance shee componens reflec differences in invesmens and financing ha are significanly relaed o public-privae saus, afer conrolling for bank size, and are herefore poenially useful predicor variables. From he regressions in Table 3, we choose he se of firs-sage predicor variables from he se of invesmen and financing variables ha are significanly relaed o Dpub, afer conrolling for size. We augmen ha se of predicor variables wih several addiional variables ha ex ane seem likely relaed o ownership saus: size, profiabiliy (measured as reurn on average common equiy, ROACE), earnings growh (denoed NI), and credi risk (measured as loan loss provisions as a percen of oal asses, LLP). Our selecion model, which we esimae over he pooled cross-secional sample, akes he form: Dpub = δ 0 ComLns OhDeb ROACE Cash NI AgLns Pr efequiy Securiies LLP OhLns 14 + ε 3 9 ConCap FamilyLns Re serves Re Earn ConsumerLns GWOI OCI 5 Deposis 17 ComRELns We presen he resuls of esimaing he probi selecion model in Table 4. The Pseudo R-square saisic indicaes he model explains roughly 50 percen of he cross-secional variaion in he selecion of public-privae ownership saus wihin our sample. No surprisingly, size is an exremely srong posiive predicor of ownership saus. We use he parameer esimaes repored in Table 4 o compue an inverse Mills raio for each sample bank (which we denoe Lambda). Lambda reflecs he condiional likelihood a given bank is public or privae. In he second sage, we es he effecs of ownership saus on Size (2) 20