Why Do Banks Hide Losses?

51 Pages Posted: 27 Feb 2019 Last revised: 16 Jun 2020

See all articles by Thomas Flanagan

Thomas Flanagan

University of Michigan, Stephen M. Ross School of Business

Amiyatosh Purnanandam

University of Michigan, Stephen M. Ross School of Business

Date Written: February 6, 2019

Abstract

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

Flanagan, Thomas and Purnanandam, Amiyatosh, Why Do Banks Hide Losses? (February 6, 2019). Available at SSRN: https://ssrn.com/abstract=3329953 or http://dx.doi.org/10.2139/ssrn.3329953

Thomas Flanagan

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

Amiyatosh Purnanandam (Contact Author)

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

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