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Bank Deregulation and Stock Price Crash Risk

Journal: Journal of Corporate Finance

Date: 2022

Author: Viet Anh Dang, Edward Lee, Yangke Liu, Cheng Zeng

Abstract:
This paper examines the influence of bank branch deregulation on corporate borrowers' stock price crash risk. Using a large sample of U.S. public firms over the period 1962-2001, we provide robust evidence that intrastate branch reform contributes to the reduction of firms' stock price crash risk. Further analysis shows that the negative relation between bank branch deregulation and crash risk is more pronounced among firms that are more dependent on external finance and lending relationships, as well as firms that have weaker corporate governance and greater financial constraints. Our findings are consistent with the notion that bank branch reform improves bank monitoring efficiency, thereby reducing borrowing firms' bad news formation and hoarding, and hence their stock price crash risk. Overall, our empirical evidence suggests that, as a reform aimed at removing restrictions on bank branch expansion, bank deregulation also helps protect shareholders' wealth.

Link: Google Scholar

Background and Context

Research Setting

This study examines how the removal of U.S. state-level restrictions on bank branch expansion between 1970-1990s affected stock price crash risk for firms borrowing from banks.

Methodology

The research uses a quasi-natural experiment analyzing 79,231 firm-year observations from 8,512 U.S. public companies between 1962-2001, comparing firms before and after their states implemented bank branch deregulation.

Key Question

Does allowing banks to expand their branch networks improve their ability to monitor borrowing firms and reduce these firms' stock price crash risk?

Timeline of State-Level Bank Branch Deregulation Shows Staggered Implementation

  • Shows how bank branch deregulation was implemented gradually across different states over time
  • Peak implementation occurred in 1985-1989 when 15 states deregulated
  • This staggered implementation helps identify the causal effect of deregulation

Bank Deregulation Reduces Stock Price Crash Risk

  • Shows significant reduction in two measures of stock price crash risk after deregulation
  • NCSKEW (negative skewness of returns) decreased by 14%
  • DUVOL (down-to-up volatility) decreased by 12.7%

Impact Stronger for Firms Dependent on External Finance

  • Effect of deregulation is stronger for firms more dependent on external financing
  • Firms with high external finance dependence show 4.75 times larger reduction in crash risk
  • Supports the bank monitoring channel as these firms are more affected by bank oversight

Mechanism: Improved Bank Monitoring Reduces Bad News Hoarding

  • Financial restatements decreased by 1 percentage point after deregulation
  • Accounting conservatism increased by 5.2 percentage points
  • Indicates improved financial reporting quality and reduced bad news hoarding

Stronger Effects for Firms with Weaker Governance

  • Firms with weaker governance show stronger reductions in crash risk
  • Effect strongest for firms with low institutional ownership
  • Suggests bank monitoring substitutes for other governance mechanisms

Contribution and Implications

  • Shows that banking sector reform can have positive spillover effects on stock market stability
  • Demonstrates that improved bank monitoring can substitute for weak corporate governance
  • Provides evidence that regulatory changes in lending markets can protect shareholder wealth

Data Sources

  • Deregulation Timeline: Constructed from Table 1 showing state-by-state deregulation dates
  • Crash Risk Reduction: Based on economic significance calculations from Table 3
  • External Finance Impact: Derived from interaction terms in Table 7
  • Monitoring Mechanisms: Based on mediation analysis in Table 11
  • Governance Effects: Constructed from interaction coefficients in Table 9