Numerous banks and other financial institutions have failed or were bailed out by

governments around the world since the start of the financial crisis in 2007. It
appears that these widespread failures, as well as the recent, massive writedowns of loans in the banking industry, came as a surprise to regulators and the
financial community. However, Pakistan banking industry was not affected much
due to this crisis.
The global financial crisis in 2008-09 which are still on the go, they actually
started from the 20 th century and they have been increasing since then. In the end of 20th
century the U.S housing prices after a multiyear started declining, the mortgage prices
had been at a very high rise before that and suddenly they started declining at the end of
20 th century. Around mid 2008 there was a striking increase in the mortgage d e l i n q u e n c i e s . T h i s
increase was also followed by mortgages and this great loss in value meant an
e q u a l l y g r e a t d e c l i n e i n t h e c a p i t a l o f Am e r i c a s l a r g e s t b a n k s a n d trillion dollar
government. This also affected the backed mortgages lenders like Freddie Mac and Fannie. Outside
of
the
U.S,
the
bank of
China
and
France
BNP Paribas
were
the
firsti n t e r n a t i o n a l i n s t i t u t i o n s t o d e c l a r e s u b s t a n t i a l l o s s e s f r o m s u b p r i m e c a t a s t r o
phe,Ireland, Portugal, Spain and Italy were the worst hit. The U.S Federal
R e s e r v e , t h e European Central bank, the bank of Japan, the reserve bank of Australia
and the bankof Canada all began injecting huge chunks of liquidity into the banking system.
France,G e r m a n y a n d t h e U n i t e d K i n g d o m a n n o u n c e d m o r e t h a n $ 2 2 2 b i l l i o n o f
n e w b a n k liquidity and nearly $1 trillion in interbank loan guarantees, towards the end of
2007, ithad become quite clear the subprime mortgage problems were truly global in
nature.The global financial crises also effects South Asian exports and could hurt income. Pakistan is
another country in South Asia that has been severely affected by the f i n a n c i a l c r i s e s . I n f a c t ,
P a k i s t a n s e e m s t o b e o n e o f t h e h a r d e s t h i t w i t h t h i s g l o b a l crisis. Its economy is
already in crises. Pakistan is also facing a serious liquidity crunch, w i t h t h e o n l y s o l u t i o n b e i n g
i n t e r n a t i o n a l s u p p o r t . S a u d i Ar a b i a h a s r e f u s e d t o g i v e Pakistan a financial concession
on the oil trade, as well. The only option for Pakistan is to approach international monetary fund,
which will set highly stringent conditions for thenation

Pakistans banking sector is made up of 53 banks, which include thirty commercial banks,
four specialized banks, six Islamic banks, seven development financial institutions and six
micro-finance banks.
According to the 2007-08 Financial Stability Review from the State Bank of Pakistan (SBP),
'Pakistans banking sector has remained remarkably strong and resilient, despite facing
pressures emanating from weakening macroeconomic environment [sic] since late 2007'.
According to Fitch Ratings, the international credit rating agency with head offices in New
York and London, 'the Pakistani banking system has, over the last decade, gradually evolved
from a weak state-owned system to a slightly healthier and active private sector driven
system'.
The data from the banking sector for the final quarter of 2008 confirms a slowdown after a
multi-year growth pattern. In October 2008, total deposits fell from Rs3.77 trillion in
September to Rs3.67 trillion. Provisions for losses over the same period went up from Rs173
billion in September to Rs178.9 billion in October. At the same time, the SBP has jacked up
interest rates: the 3-month treasury bill auction saw a jump from 9.09% in January 2008 to
14% in January 2009, and bank lending rates are now as high as 20%.
Overall, Pakistans banking sector has not been as prone to external shocks as have been
banks in Europe. Liquidity is tight, certainly, but that has little to do with the global financial
crisis and more to do with heavy government borrowing from the banking sector, and thus
tight liquidity and the crowding out of the private sector (Pakistan & Global Financial Crisis
by Dr Farukh Saleem)
Impact on Pakistan Banking Industry
According to Fitch ratings, the Pakistani banking system has, over the last
decade, gradually evolved from a weak state-owned to a slightly improved and active
private sector motivated system. But as of end 2008, data from the banking
s e c t o r confirms a slow down. As of October 2008, total deposits fell from Rs 3.77 trillion

in September to Rs 3.67 trillion. Provisions for losses over the same period went up from
Rs 173 billion in September to Rs178.9 billion in October. Market analyst Muhammad Suhail
told the Los Angeles times. The global crisis has really fuel to the fire. There was a time
window earlier this year to address all this, and we missed it. The drying up of credit
internationally has hit Pakistan hard with the banking system suffering a severe liquidity
problem. Overnight call rates rises so much and its ranging from 32 to 40 percent

In this study, we examine whether and to what extent accounting and audit
quality variables provided indications of these subsequent bank failures.
Evidence on the ability of accounting and auditing information to ex ante
distinguish failed banks from other banks adds to the literature on the predictive
ability of accounting and auditing information, and is relevant to decisions to
enhance the effectiveness of current regulations on bank financial reporting and
monitoring. To our knowledge, no other study has examined the role of bank
financial reporting and auditor reputation in the recent financial crisis.
Several regulations affect bank financial reporting, including the Federal Deposit
Insurance Corporation Improvement Act of 1991 (FDICIA) which imposed new
auditing, corporate reporting, and governance reforms on depository institutions
with assets exceeding $500 million (increased to $1 billion in 2005) and on its
auditors (Murphy, 2004). More specifically, FDIC regulations require the
management of these institutions to evaluate the internal control over financial
reporting and the auditor to attest to the report on the effectiveness of internal
controls over financial reporting.
These regulations, especially the internal control requirements on financial
reporting, were passed ostensibly to enhance the transparency of reported
financial information. Given this, whether and how accounting and audit
properties indicated impending bank failure during the recent financial crisis are
interesting and important questions.
While much of the recent literature emphasizes the role of subprime lending and
loan securitization in the financial crisis, other research focuses on the role of
valuation issues and risk disclosures.
In particular, the debate on the role of fair value accounting in the financial crisis
has taken center stage (Ryan, 2008; Laux and Leuz, 2009). Unlike that research,
our study focuses on the ability of primary accounting and audit quality variables
to predict bank failure.
We examine the ability of accounting and audit quality variables measured in the
four quarters of 2006 (i.e., prior to the financial crisis), to predict whether a bank
will fail in 2007 or later. The accounting variables include balance sheet strength,
loan quality and
loan mix, and financial reporting discretion. We use Tier 1 capital ratio to
measure balance sheet strength, level of nonperforming loans, growth in various
loan categories, and loan portfolio mix to measure loan quality and loan mix, and
loan loss provisions (LLP) to measure financial reporting discretion. We use
auditor type (Big 4 vs. non-Big 4 auditors) and auditor industry specialization to
measure audit quality.
We obtain data from the Federal Reserve Bank of Chicagos Bank Holding
Company quarterly database which includes both public and private banks. We
conduct our analysis on two samples: (1)
a sample of troubled banks (hereafter referred to as the troubled banks sample)
identified based on profitability, loan quality, and balance sheet position in 2007,
and (2) a sample that includes all failed and not-failed banks (hereafter referred
to as the full sample).
We analyze the troubled banks sample separately because regulators and
investors likely are most interested in what distinguishes banks that fail from
banks that are troubled but do not fail. The troubled banks sample includes 4877

bank-quarter observations representing 1248 banks, and the full sample includes
25,428 bank-quarter observations representing 6437 banks. We test our
predictions separately on each of these samples.
Our empirical analysis using the troubled banks sample identifies six reliable
predictors of bank failure. These include auditor type, auditor industry
specialization, Tier 1 capital ratio, proportion of securitized loans, growth in
loans, and loan mix. For the larger full sample of banks, we identify the following
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.
To our knowledge, this study is the first to document the impact of audit quality
on bank failure. Auditors have intimate knowledge of their clients financial
health and high quality auditors have incentives to safeguard their reputation.
Our finding that banks audited by reputable auditors have lower probability of
failure is consistent with this notion. Just prior to the financial crisis, the FDICIAimposed auditing and internal control regulations were relaxed for a sub-sample
of banks (the asset threshold for compliance was increased from $500 million to
$1 billion in 2005). In this regard, our results are relevant to policy makers in
their future deliberations on auditing requirements and asset thresholds. Prior
research indicates that the recent banking crisis in the US and the past banking
crises during the 1980s and 1990s resulted primarily from credit problems. Our
results confirm this finding.
We document that lack of loan diversification (loan mix), problem loans (higher
nonperforming loans and higher loan loss provisions), recent crisis. These results
are useful for regulators in identifying forward-looking variables for their bank
surveillance models.
The rest of this paper is organized as follows. The next section discusses the
research background and the relation between accounting and audit variables
and troubled banks. Section 3 details the sample selection, Section 4 discusses
the results, and Section 5 provides the conclusions of the study.
2. Research background
The extant literature in banking (Oshinsky and Olin, 2006) identifies low capital
and risky assets as major reasons for bank failure.
We predict that selected accounting variables and auditor reputation variables
provide important information on the future health of a bank.
2.1. Accounting properties of failed banks The accounting factors we study are
loan loss provisioning, balance sheet strength, and loan quality and mix. As
noted in Barth and Landsman (2010), on average, loans comprise a significant
proportion of bank assets, and therefore banks financial reporting for loans,
particularly loan loss provisioning, is critical in determining the health of a bank.
Higher LLP in the pre-crisis period could signify that bank managers are more
conservative in their estimates or that bank managers are more prompt in
recognizing loan losses.
Alternatively, higher LLP could signal future trouble, since managers have private
information on loan quality and default risk. Given these competing arguments,
we do not make a directional prediction on the coefficient of LLP.
We use Tier 1 capital ratio (CAP) measured in 2006 (i.e., prior to the onset of the
financial crisis) as the proxy for balance sheet strength. A higher capital ratio
provides a bigger cushion for banks to write-off bad loans in the future (Berger et
al., 1995; Kim and Kross, 1998). Additionally, banks with higher capital likely
suffer less from debt overhang problems (Myers, 1977) and have more flexibility
to respond to adverse shocks (Beltratti and Stulz,

2010). Therefore, we expect CAP is negatively related to the probability of bank

failure.
We proxy loan quality and loan mix with the following variables: proportion of
securitized assets to total assets (PSLOANS), level of nonperforming loans (NPL),
growth in various loan categories, and loan portfolio mix (LOAN_MIX). As in
Kashyap et al. (2008), we predict PSLOANS is positively related to the likelihood
of failure, as a higher level of securitized assets is more likely to lead to
subsequent bank failure. Banks are required to disclose nonperforming loans
(NPL), which are loans that are more than 90 days past due. NPL is relatively
nondiscretionary and is a timely source of information about loan default (Liu and
Ryan, 2006).
Prior research (e.g., Wahlen, 1994; Kanagaretnam et al., 2004;
Fonseca and Gonzlez, 2008) documents higher NPL is associated with lower
loan quality. Accordingly, we expect NPL is positively related to whether a bank
subsequently fails. The effect of growth in individual loan categories and total
loans on future bank failure is dependent on the quality of incremental loans.
However, large growth in risky loans most likely increases the probability of a
bank failing. In particular, incremental loans associated with inflated assets
during asset bubble periods may pose higher risk than growth in loans of other
categories (Bhattacharyya and Purnanandam, 2010). Consistent with this
argument,
we are more likely to observe a positive association between growth in
residential mortgages (i.e., 14 family residential mortgages) and future bank
failure.
Liu and Ryan (2006) document a negative relation between loan portfolio mix
and future loan write-offs. We measure LOAN_MIX as the proportion of
heterogeneous loans such as commercial and industrial loans, direct lease
financing, all other real estate loans, agriculture loans, and foreign loans to total
loans. If LOAN_MIX is high, it indicates that the loan portfolio is diversified and
suggests that the bank is exposed to lower default risk. Therefore, we predict a
negative relation between LOAN_MIX and subsequent bank failure.
2.2. Audit properties of failed banks
In addition to the accounting variables, we examine the relation between audit
quality and the likelihood of a bank failing. Given that auditing is an important
external monitoring mechanism, high quality auditing likely reduces the
probability of a bank getting into trouble and subsequently failing. In addition,
auditing banks is more complex than auditing industrial firms. This is supported
by the American Institute of Certified Public Accountants (AICPA, 2006) Center
for Public Company Audit Firms May 2006 report on large firm Public Company
Accounting Oversight Board (PCAOB) inspection deficiency analysis, which finds
that banks loan loss allowance ranks number one among the various
deficiencies found by inspectors. The findings of this report indicate that auditing
the loan loss allowance and the related loan loss provision are challenging tasks
for auditors in general. Given the complexity of auditing banks and given that
high-reputation auditors have strong incentives to provide high-quality audits to
avoid jeopardizing their reputation capital, audit quality likely plays an even
more important role in assuring the quality of banks financial information.
Additionally, FDICIA imposed new auditing, corporate reporting, and governance
reforms on depository institutions (both public and private) with assets
exceeding $500 million (increased to $1 billion in 2005) and on its auditors
(Murphy, 2004). These regulations require the management of these institutions
to evaluate the internal control over financial reporting and the auditor to attest
to the report on the effectiveness of internal controls over financial reporting.

Thus, auditors play an active role in ensuring that the financial reporting quality
is high for large banks.
Specifically, we examine two aspects of auditor reputation.
First, we investigate the implications of auditor type (Big 4 vs. non-Big 4 auditors)
for bank failure. A large body of empirical research documents a positive
association between audit quality and Big 4 auditors for industrial firms (Teoh
and Wong, 1993;Craswell et al., 1995; Becker et al., 1998). Relative to non-Big 4
auditors, Big 4 auditors have greater expertise, resources, and more importantly,
market-based incentives (e.g., mitigating the risk of litigation and protecting
their reputation capital) to constrain the tendency of their audit clients to engage
in aggressive reporting or fraud.
Although empirical evidence on auditor reputation and audit quality in the
banking industry is limited, the economic incentives faced by the Big 4 auditors
of banks are similar to those of other industries, i.e., preserving reputation
capital and mitigating the risk of litigation. In addition, auditor type may be of
higher importance in industries such as banking, where information uncertainty
is higher relative to industrial firms due to the greater complexity of banking
operations and difficulty of assessing risk on the large and diverse portfolio of
loans (Autore et al., 2009). Given the above, we predict a lower probability of
failure for banks audited by Big 4 auditors. Second, we examine the relation
between auditor industry specialization and the likelihood of a bank failing. We
measure auditor industry specialization/expertise by an auditors industry market
share. Auditors who are specialists in the banking industry can better assess the
adequacy of the loan loss provision and loan loss
allowance than non-specialist auditors. Several studies have examined the
benefits of auditor industry specialization or expertise on audit effectiveness for
industrial firms (Bedard and Biggs, 1991; Carcello and Nagy, 2004; Krishnan,
2003). Overall the evidence from existing literature indicates that auditor
industry specialists are better able to detect material misstatements in financial
statements.
In the banking industry, Kanagaretnam et al. (2009) find that once auditor type
and auditor industry expertise are separated, only industry expertise significantly
impacts the valuation of discretionary LLP. In summary, the collective evidence
indicates that auditor industry specialization enhances audit effectiveness and
the credibility of financial statements. Additionally, in an international banking
setting, Kanagaretnam et al. (2010) find that auditor industry specialization
constrains earnings management.
Based on these findings, we predict a lower probability of failure for banks
audited by industry specialists.
3. Sample selection
We obtain 2006 quarterly data and 2007 annual data on private and public banks
from the Bank Holding Company quarterly data files available from the Federal
Reserve Bank of Chicagos website.
We use the 2006 quarterly data to measure the accounting and auditing
predictor variables, and the 2007 annual data to identify troubled banks in
2007.7 The initial Bank Holding Company sample has 40,760 bank-quarter
observations and the final full sample includes 25,428 bank-quarter observations
for which we have complete data, and represents 6437 banks. We classify banks
in this sample as troubled banks if they failed after 2006 or if they meet the
following three conditions in 2007: (1) Tier 1 capital ratio is less than 4%; (2) loan
loss provision divided by total loans is greater than 1%; and (3) ROA is less than
_5%. The troubled banks sample includes 4877 bank-quarter observations for
which we have complete

data, and represents 1248 banks.8,9 We identify failed banks from the list
published by FDIC.
We employ simple univariate analysis (of mean differences between failed banks
and not-failed banks) and more detailed multivariate analysis to test our
predictions. First, we identify banks that became troubled in 2007 or later.
Panel A of Table 1 reports descriptive statistics for the variables used in the
regressions for
the troubled banks sample. We report the means and standard deviations of the
variables for failed banks and not-failed banks separately and compute the
differences in their means. About 8.1% and 9.2% of the sample observations are
audited by Big 4 auditors for failed banks and not-failed banks, respectively.11
About 5.5% and 5.9% of the sample observations are audited by KPMG and PwC
(the two bank specialist auditors according to GAO (2003)) for failed banks and
not-failed banks, respectively. Neither