This paper explores the relationship between managers’ labor mobility and the financial reporting quality of banks. Using the state-level adoption of the Inevitable Disclosure Doctrine (IDD) as an exogenous shock discouraging labor mobility, we show that adoption of the IDD is associated with a decline in financial reporting quality, as measured by discretionary loan loss provisions. The effect is larger for banks with managers who have limited outside job opportunities and smaller for banks with tight regulatory oversight. Our results support the view from the career concern hypothesis that bank managers facing restrictions on mobility have greater incentives to engage in discretionary accounting.
Since the 2008 global financial crisis, accounting and finance researchers have shown considerable interest in bank transparency. The crisis highlighted the economic impact of bank opacity and gave rise to the notion that a lack of information on bank asset quality can harm financial stability. The opacity of banks can exacerbate agency problems by hindering market discipline, and increase the risks of panic and contagion during a crisis (Nier and Baumann, 2006, Morgan, 2002). During the recent global financial crisis, investors sought information on banks’ exposure to risks, but this was not readily available. Along with explicit government backing of the banking system, the public disclosure of stress test results helped to relieve the panic by providing investors with the needed information (Jungherr, 2018).1 Since then, extensive literature has discussed how much transparency in banking should be required, and how transparency affects financial stability (see Acharya and Ryan (2016) for a survey). There is, however, still a paucity of research identifying the determinants of bank transparency, despite the necessity of effective monitoring and regulations. We aim to fill this gap by examining the effect of bank managers’ labor mobility on financial reporting quality.
In this paper, we define labor mobility as the degree of friction in the labor market, in terms of how easily individuals can transfer from one job to another. Job switching is an important channel through which individuals increase their compensation or find better-suited jobs (Topel and Ward, 1992). Therefore, the possibility of job switching is used as leverage in negotiating compensation levels and working conditions both explicitly and implicitly. This is well demonstrated by recent retention awards to bank executives, that were granted as competition for talent intensified among banks.2 The observed efforts made by banks to retain executives imply that a restriction on labor mobility would lower managers’ bargaining power in the job market. Accordingly, managers’ career concerns would increase. In response, to secure bargaining power, managers may have higher incentives to window-dress their performance by distorting information disclosed to the public. Consequently, the financial reporting quality would be compromised (hereinafter, we refer to this proposed effect as the career concern hypothesis). There are a number of studies on industrial firms testing and supporting this hypothesis (Ali et al., 2019, Chen et al., 2018, Tang et al., 2021), but not yet for banks.
The 2008 global financial crisis confirmed a longstanding concern around bank opacity, namely that a lack of information on banks’ asset quality can lead to greater systemic risk. Given the economic impact of bank opacity, it is necessary to understand the determinants of banks’ financial reporting quality to enhance financial stability. To this end, we evaluate the effect of managerial labor mobility on financial reporting quality at banks. We focus on the degree of labor mobility because it constrains managers’ outside job opportunities, and thus affects their career concerns. This is particularly important in the banking industry because of its opaque nature. Despite the existence of accounting rules and regulations, bank managers still have some discretion over financial reporting due to their informational advantages and expertise in bank operation (Beatty and Liao, 2014; Kim and Kross, 1998; Cornett et al., 2009). We conjecture that a restriction on labor mobility motivates earnings management by triggering managers’ career concerns, and thereby impairs financial reporting quality at banks.
This paper evaluates the impact of a legal shock discouraging labor mobility (i.e., the IDD) on discretionary provisioning by banks. We find that banks accrue loan loss provisions in a more discretionary manner after their home state adopts the IDD. Rejecting the IDD has the opposite effect, i.e., reducing discretionary provisions. These results suggest that restrictions on labor mobility impair the financial reporting quality of banks, making it harder for outside investors and regulators to understand bank fundamentals. We further perform a number of tests on the heterogeneous effects of the IDD. We find larger effects of the IDD on discretionary provisioning for smaller banks, private banks, and banks with fewer peers in the local market. These results support the view that managers’ career concerns are the channel through which labor mobility affects financial reporting quality. We also use alternative measures of financial reporting quality: the validity of provisions in estimating future loan losses, and just-meeting-or-beating earnings benchmarks. Our results using the alternative measures are broadly consistent with the earlier findings. First, after IDD adoption, banks’ loan loss provisions become less accurate estimations of actual loans charged off in the subsequent period. Second, we provide evidence that IDD adoption increases bank managers’ use of accounting discretion to meet or beat an earnings benchmark.