The Effect of Industrial Sector Transparency on Bank Risk-taking and Banking System Fragility

We show real effects in the banking sector that emanate from transparency in the industrial sector. Transparent financial reporting by industrial firms facilitates access to arm’s-length financing from capital markets and diminishes these firms’ reliance on banks. Banks, as a result, face increased competition in their product markets and seek to offset their lost rents by – (i) taking on more risk, (ii) reducing their cost structures and (iii) increasing the intensity of intermediation. The net effect of these activities is to lower the likelihood of a banking crisis in countries with greater borrower transparency. Additional tests suggest that risk-taking is channeled more through non-lending than lending activities, pointing to the beneficial role of diversification in reducing bank fragility. Tests using the mandatory adoption of International Financial Reporting Standards (IFRS) as a shock to borrower transparency indicate that endogeneity is unlikely to be driving our findings. A difference-in-differences design shows that risk-taking, cost efficiency and bank intermediation in banks of IFRS adopting countries are more salient than those in non-adopting countries. Overall, we provide novel evidence that transparency of the industrial sector strengthens the banking sector. _______________________________ We appreciate helpful comments from Ashiq Ali, Anne Beatty, Andy Bernard, 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 (Dopuch conference discussant) and workshop participants at Dartmouth (Tuck), Nick Dopuch 2012 Accounting Conference, Ohio State, University of Miami, University of San Diego (Rady), University of Southern California (Marshall) and UT Dallas.