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

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 significant 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. © 2012 Blackwell Publishing Ltd