Underreporting of Bank Risk: Does Shareholder-Manager Distance Matter?

Using a regulatory change that forced commercial banks in India to reveal the extent of hidden non-performing loans (NPLs), we show that banks hide more when their shareholders are distant. Speci fically, banks with higher shareholding by foreign institutional investors (FIIs) engage in higher underreporting. These effects are stronger for banks with highly compensated CEOs. Analyzing the period leading up to the regulatory change, we find that CEO's compensation was more tightly linked to observable performance measures such as profi tability and NPLs for banks with high FII shareholding. Managers of these banks responded by reporting lower NPLs, in part by engaging in untruthful reporting. Distant shareholder should use caution in deploying high-powered compensation contracts linked to observable performance measures as a substitute for diluted monitoring: instead of solving the agency problem, it can result in perverse misreporting incentives.