Ethnic Diversity and Monitoring Effectiveness of the Board: Evidence from Banks

Synopsis The research problem We investigate the effect of ethnic diversity on the reporting quality of U.S. banks. Motivation Although the representation of ethnic minorities in the U.S. boards has increased recently, only a few studies investigated its effect on the board’s monitoring effectiveness. The test hypotheses An ethnically diverse board has a higher monitoring performance in the form of timelier loan loss provision (LLP) recognition. Target population The U.S. commercial banking sector covers the period 1996–2017. Adopted methodology Our main analysis used a fixed effect estimator. We address endogeneity concerns by using bank-fixed effects, CEO-fixed effects, and employing propensity-score-matched and entropy-balanced samples in additional tests. We use LLP, the main accrual in banks, as our measure for financial reporting quality. Our main independent variables are the ethnic diversity of the board and the ethnic diversity of the audit committee. Our ethnic diversity of the board variable is the percentage of independent non-Caucasian directors on the board. Analyses First, we regress LLP on our ethnic diversity variable, controlling for various board characteristics, CEO attributes, and the quality of banks’ information environment. We also extend our analyses to examine the effect of ethnic diversity of the audit committee on LLP timeliness. Finally, using accounting- and market-based measures of risk, we investigate whether bank risk moderates the association between ethnic diversity and LLP timeliness. Findings Our findings indicate that ethnically diverse boards provide more effective monitoring, reflected by higher earnings quality in the form of timelier LLP reporting. We also find that diverse boards are only associated with timelier LLP reporting in high-risk banks, indicating that ethnically diverse boards become more risk averse during periods of financial distress. In light of the recent increased levels of ethnic diversity in U.S. banks and the opaque financial reporting environment, our study provides evidence that ethnically diverse boards are better monitors than more homogenous ones.