Competition and the Use of Discretion in Financial Reporting: Evidence from Community Banks
57 Pages Posted: 25 Jan 2017
Date Written: January 11, 2017
This paper examines how an increase in the threat of competition distorts firms' financial reporting. I consider two channels: actions taken by managers as well as by regulators.
Using state-level changes in branching regulation, I find that geographically-constrained community banks increased their loss provisions and appeared less profitable when faced with the threat of entry by competitors. Future losses do not justify the increase in provisions. The effect is consistent with both managers' and regulators' use of discretion in financial reporting, driven by managers' entry-deterrence objective and regulators' mandate to ensure safety and soundness of the financial system.
Survey-based evidence collected as part of this study supports the premise that banks prefer to locate in markets where incumbents have high profitability and low credit losses, and that banks use competitors' financial statements in analyzing their competition. Survey evidence also suggests that regulators' expectations are a leading factor in banks' over-provisioning for loan losses.
Keywords: Financial Reporting, Product Market Competition, Entry Deterrence, Community Banking, Regulator Incentives, Loss Provisioning
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