Do banks influence stock crash risk? Evidence from banking deregulation

Abstract

An extensive literature shows that managers’ withholding of bad news, an agency problem in corporate governance, plausibly causes stock price crashes. This literature, however, has not examined whether and how lending banks influence borrowing firms’ crash risk, despite banks’ advantageous role in corporate governance via their monitoring and funding functions. We fill this void in this study. To mitigate endogeneity, we exploit the staggered reforms in U.S. state-level banking markets that gradually lift barriers for interstate branching. These deregulation events, which are exogenous to firms, represent historically important shocks to bank competition, and bank competition can fundamentally alter bank monitoring and funding behaviors. We find robust evidence that bank competition reduces firm crash risk, and the effect is stronger in scenarios in which bank monitoring and funding are likely to exert greater influences. Bank competition also mitigates abrupt divulgence of adverse information, suppresses earnings management, and improves reporting quality, which helps explain the decline in crash risk.