Why Do Banks Hide Losses?
51 Pages Posted: 27 Feb 2019 Last revised: 16 Jun 2020
Date Written: February 6, 2019
Despite plenty of anecdotal evidence of hidden losses in banks, there is no systematic study analyzing the economic drivers of this behavior: we simply do not get to observe what banks are hiding unless they are caught. Using a regulatory change in India that forced all commercial banks to reveal the extent of hidden losses, we uncover two key economic forces behind this behavior: lack of close supervision by the shareholders and high-powered managerial incentive contracts. Specifically, banks with higher shareholding by distant and passive Foreign Institutional Investors (FIIs) hide more and these effects become especially strong for banks where CEOs get highly compensated for reported profits. Our findings caution against using high-powered compensation contracts linked to observable performance measures as a substitute for diluted monitoring: instead of solving the agency problem, it can result in perverse misreporting incentives.
Keywords: Underreporting, Monitoring, Incentives
JEL Classification: G21, G28
Suggested Citation: Suggested Citation