۱- Introduction

۲- Optimal design of supervisory settings

۳- Institutional Framework

۴- Empirics

۵- Conclusion

References

Abstract

This paper investigates the role of external auditors in banking sector supervision from a theoretical, institutional and empirical perspective. We first present a simple principal-agent framework that highlights the importance of several institutional characteristics in determining the optimal involvement of external auditors in supervision. We then construct a new index that captures the degree of involvement of external auditors in the oversight of the banking sector in 115 countries. Consistent with our theoretical arguments, we find that countries that increase the role of central banks in supervision are also more likely to involve auditors, suggesting that the added complexity of a supervisory function is likely to benefit from the expertise of an external auditor. Having experienced a financial crisis is also associated with a higher use of auditors, particularly among central banks with an increasing role in supervision, which suggests some reputational concerns of the supervisor. Finally, we show that higher audit quality is associated with an increased involvement of auditors in supervision.

Introduction

In the aftermath of the 2008 Global financial crisis, researchers and policymakers alike have pointed to the weakness of banking supervisory frameworks as one of the leading causes of the crisis (see Merrouche and Nier, 2010; Kupiec et al., 2017). An effective supervision technology ought to detect, well in advance, potential threats to the safety and soudness of the banking sector. Previous research has explored various aspects of banking regulation that can achieve such objectives, including bank capital requirements, regulatory treatments of non-performing loans and provisions or disclosure requirements.1 However, little attention has been directed towards another important aspect of financial sector oversight, i.e. the use of external auditors in the implementation of specific banking supervisory tasks. The involvement of auditors, as private financial gatekeepers, can improve the credibility of the overall supervisory setting, as auditors generally have a beneficial influence on the behaviour of regulated firms, or banks in this case.2 For this reason, numerous initiatives on the global regulatory framework (such as the Basel Committee on Banking Supervision, 2008, 2014) have recommended a tight relationship between banking supervisors and external auditors to enable an effective information exchange. The supervisor can request external auditors to perform different kinds of tasks, at times going beyond the standard audit report. However, the involvement of private actors in implementing public tasks can carry risks. For example,the supervisor can incur reputational costs given that auditors are private firms with potentially close ties to the regulated financial institutions.