Monitoring the Monitors: The Effect of Banking Industry Reform on Earnings Management Behavior in an Emerging Market

• Author: Chia‐Chun Hsieh,Shing‐Jen Wu
• DOI: http://doi.org/10.1111/j.1467-8683.2012.00920.x
• Published date: 01 September 2012
• Date: 01 September 2012

Monitoring the Monitors: The Effect of Banking

Industry Reform on Earnings Management

Behavior in an Emerging Market

Chia-Chun Hsieh* and Shing-Jen Wu

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This paper studies whether enhanced regulatory supervision of the banking system strengthens

the debt contracting mechanism between borrowers and lenders in emerging markets. Specif‌ically, we investigate: 1)

whether the borrowers’ accrual-based earnings management behavior is more negatively associated with the magnitude of

their bank loans after the government strengthens the monitoring on banks, and 2) whether the enhanced supervision is

more effective for f‌irms controlled by the state, the major economic player in most emerging markets.

Research Findings/Insights: Using China’s 2003 banking reform as a natural experiment, we f‌ind that borrowers’ earnings

management behavior becomes more negatively associated with loan size after the reform. The association is more signif‌i-

cant for state-owned borrowers and lenders, consistent with the prediction that although the state-owned parties face lower

barriers to collusion, the reform increases the costs of side-contracting. Overall, the f‌indings suggest that such reform is

effective in enhancing banks’ role in corporate governance in a transition economy.

Theoretical/Academic Implications: To date, most corporate governance studies are based on the standard principal-agent

theory that analyzes contracting between only two parties. For this reason, the standard agency theory has had limited

success in explaining economic developments in emerging markets, where the economy is characterized by high levels of

government intervention (i.e., a third party), which creates the possibility of collusion. We study debt contracting in an

emerging market by adopting the theory of collusion, an extension of the traditional principal-agent theory to multi-agent

settings, such as one in which there are one principal and two agents, one of whom plays the role of supervisor. Our results

show that, consistent with theoretical predictions, monitoring by the government (i.e., the principal) of banks (i.e., the

supervisor) has an impact on the relationship between banks and borrowing f‌irms (i.e., the agents).

Practitioner/Policy Implications: Previous research on corporate governance in emerging markets, which has focused on

the disciplining role of the equity holders, has documented that corporate governance is rather weak. As private lending is

the most widely used type of f‌inancing in emerging markets such as China, this paper takes a different view and shows that

private lending has increased its inf‌luence on f‌irms’ corporate governance since a banking reform. The results conf‌irm that

the debt contracting mechanism between companies and banks has developed since such a reform.

Keywords: Corporate Governance, Debt Contracting, Bank Monitoring, Earnings Management

INTRODUCTION

Moral hazard arises for debt holders when managers

undertake risky projects thatcould result in the loss of

f‌irm value and cause conf‌licts of interest between debt and

equity holders. To reduce the likelihood of moral hazard,

covenants are used in debt contracting to give debt holders

the opportunity to review and renegotiate contracts. Debt

contracting therefore functions as an important component

of corporate governance by limiting managers’ opportunis-

tic behavior. While restrictions imposed by debt contracts

give debt holders the opportunity to monitor a f‌irm, the func-

tioning of this mechanism depends on whether these restric-

tions are properly enforced. In other words, debt holders have

to actively monitor the f‌irms for the governance mechanism

to work.

*Address for correspondence: Chia-Chun Hsieh, Departmentof Accounting, School of

Business and Management, Hong Kong University of Science and Technology, Clear

Water Bay, Kowloon, Hong Kong. Tel: 852-2358-7573; Fax: 852-2358-1693; E-mail:

achsieh@ust.hk

451

Corporate Governance: An International Review, 2012, 20(5): 451–473

© 2012 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2012.00920.x

While this standard principal-agent theory has been a

solid theoretical foundation for many corporate governance

studies, it only analyzes contracting between two parties. As

a consequence, the standard theory has had limited success

in explaining economic developments in emerging markets

or other settings in which collusion is likely. A transition

economy is often characterized by high levels of govern-

ment intervention, making the government the ultimate con-

troller and a key third party (e.g., Stiglitz, 20021). In this

setting, the government acts as a principal with multiple

agents, such as banks and general f‌irms, one of whom is

appointed as supervisor. This situation creates the opportu-

nity for collusion.

In this paper, we study debt contracting in an emerging

market by adopting the theory of collusion, or the theory of

regulatory capture (e.g., Laffont & Tirole, 1993; Tirole, 1986),

which is an extension of the traditional principal-agent

theory to multi-agent settings. Using the theory as a guide,

we envision the private lending market as a hierarchy in

which the central government is the principal, the banking

industry is the supervisor who helps the principal in moni-

toring the agents, and companies are the primary productive

agents. Specif‌ically, we examine a setting in which a regula-

tory change in the banking industry is designed to empower

banks as monitoring agents. We are interested in determin-

ing whether the increased monitoring role of banks (i.e.,

lenders) affects the accounting practices of f‌irms (i.e., bor-

rowers) (e.g., Ahn & Choi, 2009). Based on the theory of

collusion (e.g., Tirole, 1986), we predict thatthe actions taken

with a view to reforming the banking industry (e.g., improv-

ing information transparency and establishing responsibili-

ties) will reduce the side-contracting opportunities between

borrowers and lenders and thus strengthen the disciplining

role of the former, which manifests itself in a more negative

association between discretionary accruals and the magni-

tude of bank loans.

We also expect that the aforementioned relationship

between bank loans and discretionary accruals will be more

pronounced for borrowing f‌irms with high state ownership

and for borrowing f‌irms whose lender is state-owned. Spe-

cif‌ically, we hypothesize that before the reform, f‌irms with

high state ownership faced lower barriers to collusion (i.e.,

lower mobilization and transfer costs). If this was the case,

then the reform, which has changed the (transfer) costs of

collusion for state-owned borrowers and lenders, will

decrease the benef‌its of side-contracting among different

parties. As a result, after the reform the negative association

between bank loans and discretionary accruals should

become stronger for state-owned enterprises and for compa-

nies whose lenders are state-owned banks.

To study the effect of bank monitoring on corporate

accounting choices, we examine the 2003 banking reform in

China, when a supervisory agency, the China BankingRegu-

latory Commission (hereafter CBRC), was formed. We use

this event because private lending accounts for a large share

of f‌irms’ external funding in China (Allen, Qian, & Qian,

2005), and the reform in 2003 is a natural experiment on the

effect of government intervention following the f‌inancial

crisis of the late 1990s. Before the establishment of the CBRC,

there were widespread problems of outstanding nonper-

forming loans (hereafter NPLs) for banks, implying weak

corporate governance from lenders.2Our results show that,

consistent with our theoretical predictions, monitoring by

the government (i.e., the principal) of banks (i.e., the super-

visor) has had an impact on the relationship between banks

and borrowing f‌irms (i.e., the agents).

We use a sample of 750 f‌irm-years from 1999 to 2007. The

magnitude of the bank loans is used to proxy for the banks’

monitoring power, and we assume that banks have incen-

tives to continue monitoring their clients as long as the

loans remain outstanding. On the borrower side, we use the

level of (signed) discretionary accruals to proxy for borrow-

ers’ earnings management behavior (e.g., Ahn & Choi,

2009). After controlling for the factors that affect discretion-

ary accruals, we f‌ind that the size of bank loans is nega-

tively associated with the level of discretionary accruals,

and this association is stronger after the establishment of

the CBRC. This implies that earnings management behavior

through developing income-increasing accruals is con-

strained by the government imposed monitoring of the

banking industry.

As the theory predicts, we also f‌ind that the above asso-

ciation is only signif‌icant for f‌irms with high state owner-

ship, and not for f‌irms with low state ownership. This

f‌inding appears to support the notion that stateowners faced

lower cost of collusion prior to the reform and that the

government intervention had the most impact on this group.

We further explore the effect of the reform on four major

state-owned commercial banks (hereafter SOCBs), as these

banks accumulated a large number of NPLs before the

reform. The results suggest that the monitoring power of the

SOCBs was weak before the reform and thattheir borrowers’

earnings management behavior was reduced post-reform.

Compared with other commercial banks, the SOCBs show

more signif‌icant improvement in terms of monitoring bor-

rowers’ earnings management behavior.

Furthermore, we f‌ind that during the pre-reform period,

banks’ monitoring mechanisms were effective when their

borrowers were audited by international auditors. This

implies that high quality auditors play a signif‌icant role in

assisting banks to mitigate borrowers’ upward earnings

management behavior when banks’ governance is weaker.

However, we do not observe the same effect during the

post-reform period. Instead, we f‌ind that bank loans are

signif‌icantly and negatively associated with the magnitude

of discretionary accruals and, for a given loan size, auditor

quality does not have any additional impact. The results

suggest that banks have a stronger direct impact on the

borrowers after the reform, further proving the effectiveness

of the 2003 banking regulation.

This paper contributes to the corporate governance litera-

ture by examining a circumstance in which the borrower-

lender relationship cannot be fully explained by the

principal-agent theory, which assumes that contracts are

complete and factor markets are eff‌icient (e.g., Grossman &

Hart, 1986; Hart & Moore, 1990). Thefact that NPL problems

persisted for such a long time suggests that in an emerging

market such as China, shareholders are not the (only) ulti-

mate residual claimant, as assumed by the standard theory.

We therefore expand our analysis of NPL problems by con-

sidering the government,the banking industry, and the com-

panies under a principal/supervisor/agent structure, as

452 CORPORATE GOVERNANCE

Volume 20 Number 5 September 2012 © 2012 Blackwell Publishing Ltd