Does internal control matter to banks' operational efficiency?

Abstract

PurposeThis study aims to examine whether and how the quality of internal control over financial reporting (ICFR) affects banks' operational efficiency.Design/methodology/approachFirst, the authors use a two-stage, nonoriented, variable-returns-to-scale slack-based data envelopment analysis model to calculate banks' operational efficiency. Second, the authors use cross-sectional Tobit and ordinary least squares regressions to test the hypotheses. Third, the authors use propensity score matching and entropy balancing to control for omitted variables and model misspecification and use the Heckman two-stage treatment-effect model to address self-selection bias. Finally, the authors conduct a structural equation model to identify how ICFR affects banks' operational efficiency.FindingsThe results corroborate that banks' operational efficiency is negatively associated with ineffective ICFR. This negative association is more pronounced when internal control weaknesses relate to revenues, restatements or fraud and when banks have higher human capital, lower board independence and lower free cash flows. Moreover, banks improve operational efficiency by remedying material weaknesses in their ICFR. The findings remain robust across various analyses, including change analyses, alternative measures of ineffective ICFR and operational efficiency, additional control variables and the exclusion of banks during financial crises, COVID-19 and those not under Federal Deposit Insurance Corporation Improvement Act.Practical implicationsThe findings inform managers and regulators that effective ICFR complements other bank regulations and boosts banks' operational efficiency.Originality/valueThe research shows that effective ICFR is a key driver of banks' operational efficiency, contributing to ongoing debates and mixed evidence.