Narrow Results

The Sarbanes–Oxley Act (SOX) of 2002 and the 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act (DFA) were passed to address weaknesses in the internal control environment of the firm. Elements of these Acts reduce risky behavior of financial institutions by reducing informational asymmetry with borrowers. An important element of managing earnings quality in financial institutions is the loss provision, an annual expense set aside for uncollected loan and lease payments. These Acts affect the selection of loss provision expense levels in distinct ways. Using a dataset of community bank financial information observed between 1998 and 2017, it is shown that banks experience a complementary effect between SOX and DFA on loss provision expenses. Improved governance procedures to establish policy responses to nonperforming loans result in reduced expenses, whereas reduced information asymmetry tends to enhance a moral hazard effect. These results show that incentives for firm growth, income, capital, and loan specialization under the SOX and DFA regulatory environments complicate the loan risk management process.

Financial institutions’ heterogeneity, a high degree of dissimilarity across multiple dimensions, including business focuses, correlated asset holdings, capital structures, and funding sources, reduces systemic risk. We empirically test this hypothesis using a bank holding company (BHC) level heterogeneity index based on granular balance sheet, income statements, cash flow statements, and off-balance-sheet information for U.S. bank holding companies over a sample period spanning the second quarter of 2000 to the fourth quarter of 2021. We find that the BHC-level heterogeneity negatively correlates with BHC-level systemic risk, SRISK, measured both at the global and local levels. We also construct a sector-heterogeneity index and demonstrate that a reduction of heterogeneity occurred in the U.S. financial sector prior to both the Great Recession (2007–2009) and the COVID-19 Recession, especially for the largest BHCs. As such, a declining level of financial sector heterogeneity may exacerbate the consequences of systemic shocks.

This chapter examines the relationship between financial performance, regulatory reform, and management of community banks. The consequences of the Sarbanes–Oxley Act (SOX) and Dodd–Frank Act (DFA) regulations are observed. Risk management responses to regulatory reforms, as observed in the loan loss provision, are examined in relation to these reforms. We also observe the consequences of compliance costs on product offerings and competitive condition. Empirical methods and results provided here show that sustained operations for community banks will require a commitment to developing management expertise that observes the consequences of regulatory objectives at the firm level.