Abstract/Summary

Joining the debate on the banking sector’s impact on the real economy, this study examines the impact of banks’ market power on local businesses’ financial reporting quality. Based on the market power hypothesis and the information-based hypothesis, we propose four ways the banking market could affect the financial reporting quality. The proposed mechanisms suggest that borrowers and bank lenders face increased market power by implementing different earnings management and monitoring practices. Our documentary evidence suggests that since the banking market deregulation, restrictions on inter- and intra-state banking and branching have been removed, with banks gaining more power and the market becoming more consolidated. Using a large sample of U.S. listed firms from 1995-2019, we find a favourable impact of bank market power on corporate financial reporting quality, primarily driven by heightened monitoring by banks with greater market power, supporting the monitoring-stringent conjecture. In addition, this positive relationship is more pronounced among firms heavily reliant on local banks. Our results are robust to a rich set of tests, such as using alternative measurements for financial reporting quality and bank market power, including macroeconomic factors, and considering drastic changes in the bank market structure. We also address the endogeneity concerns and test the robustness of our key findings in a loan syndication setting. Our research suggests that facing increased bank market concentration and power, firms must pay additional attention to their financial reporting, which is widely used to access external finance.