The Impact of Bank Restatements on Illiquidity and Systemic Risk

Abstract

This paper examines the determinants and consequences of restatements in U.S. banks. First, the causes of restatements in banks are examined. I find that risky, poor performing banks with low capital levels and high magnitudes of discretionary loan loss provisions are more likely to restate.Second, the consequences of restatements in banks are examined. Banks experience increased cost of equity capital and decreased balance sheet liquidity after a restatement, consistent with the view that banks are being punished for the increased opacity following a restatement. In addition, banks subject to restatements contribute more to systemic risk than other banks and thereby have spillover effects on the financial system.Overall, this paper shows firstly, that banks manage capital with loan loss provisions to avoid regulatory costs prior to a restatement. Secondly, it shows that capital providers demand a higher risk premium to compensate for the higher uncertainty following a restatement and that this has material effects on the financial system through higher balance sheet illiquidity and higher contribution to systemic risk.