Do Bank Regulation and Supervision Displace Bank Auditing?

We hypothesize that bank regulation and supervision reduce inherent and control risk in audits of banks, thereby enabling auditors to expend less effort on these audits than on audits of similar firms. We show that banks exhibit fewer internal control and accounting problems, as indicated by material internal control weaknesses and financial statement restatements, than do similar firms. We show that auditors expend less effort, as indicated by lower audit fees and shorter audit report lags, in audits of banks than in audits of similar firms, more so when bank regulation and supervision are more intense. Lastly, we show that banks are more likely than similar firms to exhibit two types of earnings management that are of minor concern to bank regulators and supervisors but are known to have capital market consequences: more frequent small positive earnings changes and longer strings of earnings increases. These results suggest that reduced audit effort yields lower market discipline over banks.