The Effect of Operational Control Quality on Operational Efficiency and Cost of Capital: Evidence from U.S. Bank Holding Companies

Recent high profile and costly operational risk events have focused the attention of bank managers and regulators on operational risk management practices since the early 2000s. This led the Basel II Accord to recognize operational risk as a separate risk. In this study, I examine whether operational control quality is associated with operational efficiency and the costs of debt and equity capital for a large sample of U.S. bank holding companies. I measure banksâ operational control quality using two measures: (1) the incidence of actual operational risk events as an ex-post observable proxy for weaknesses in operational controls, and (2) an index-based measure of operational risk management quality (ORMQ) as an ex-ante proxy, created via textual analyses of Form 10-K filings. First, I find that operational efficiency, derived from a frontier analysis, is significantly higher among banks with higher operational control quality. Second, I find that banks with stronger operational controls are associated with lower costs of debt and equity capital. These results are incremental to controlling for the quality of the internal control over financial reporting. Furthermore, in the changes analyses, I find that remediating firms exhibit higher operational efficiency and lower cost of capital estimates, while non-remediating banks are associated with no significant change in their operational efficiency estimate but exhibit a significant higher cost of capital. I also examine the net effect of operational control quality on equity valuation and find a positive association between operational control quality and equity prices. In addition, I observe that banks with higher operational control quality exhibit higher earnings persistence. Overall, the findings of this thesis suggest that operational controls have significant effects on banksâ operations and cost of capital, and that the operational risk information in banksâ Form 10-K filings is credible.

Department dc:contributor.department

Management

Year dc:date.issued

2016

Author dc:creator

• Saiy, Sasan

Advisors dc:contributor.advisor

• Mohanram, Partha S.
• Richardson, Gordon D.

Handle dc:identifier.uri

http://hdl.handle.net/1807/79734

OAI identifier oai:identifier

oai:utoronto.scholaris.ca:1807/79734