Abstract
What are the pros and cons of involving external auditors in banking supervision? This paper investigates the relationship between banking supervision and the involvement of external auditors from a theoretical and empirical perspective. We first provide a simple principal-agent framework that highlights the importance of several country-specific institutional characteristics in determining an optimal level of involvement of external auditors in banking supervision. We then propose a new index that captures the degree of involvement of external auditors in financial sector supervision. We construct this index for a broad set of 142 countries and show that countries characterized by higher levels of auditor involvement in supervision are less likely to experience a financial crisis. These results provide new and original empirical evidence on the link between regulatory and supervisory institutional designs and the probability of financial distress.
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