Ability of Accounting and Audit Quality Variables to Predict Bank Failure During the Financial Crisis

We examine the ability of selected accounting and audit quality variables measured in a period prior to the financial crisis (i.e., the four quarters of 2006), to predict banks that subsequently failed during the financial crisis. These predictor variables include balance sheet strength, loan characteristics, financial reporting discretion, and auditor type and auditor industry specialization. We employ two sets of samples from the US: a troubled banks sample that includes banks that failed in or after 2007 as well as banks classified as being troubled based on profitability, loan quality, and balance sheet position in 2007, and a full sample that includes all banks with available required data. Using the troubled banks sample, we identify five reliable predictors of bank failure: auditor type, Tier 1 capital ratio, proportion of securitized loans, growth in loans, and loan mix. For the larger full sample of banks, we identify ten predictors of bank failure: auditor type, Tier 1 capital ratio, proportion of securitized loans, nonperforming loans, loan loss provisions, growth in commercial loans, growth in real estate loans, growth in overall loans, loan mix, and whether the bank is a public bank