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Goodhart’s law in China: Bank branching regulation and window dressing

Author

Listed:
  • Gong, Di
  • Huizinga, Harry
  • Li, Tianshi
  • Zhu, Jigao

Abstract

After the removal of geographic restrictions on branching in 2006, China’s city commercial banks (CCBs) can apply for permission to branch outside their province. This paper shows that CCBs report a higher provision coverage ratio (PCR) before filing an application, thereby making the bank look safer to regulators. Our finding is robust to controlling for possible endogeneity of the branching application decision by employing propensity score matching estimators, and it is confirmed when we consider a quasi-natural experiment of deregulation reversal. Tests of the dynamic effects show evidence of reversals in PCR adjustment after applications. Higher PCR before branching applications cannot be explained by alternative rationales for manipulating loan loss reserves such as fundamental provisions, earnings management, capital management, and market signaling. Window dressers receive more supervisory penalties after filing applications relative to other branching banks. Our finding of window dressing in response to bank branching regulation confirms Goodhart’s insight that when a regulatory metric becomes a target, it ceases to be a good measure.

Suggested Citation

  • Gong, Di & Huizinga, Harry & Li, Tianshi & Zhu, Jigao, 2023. "Goodhart’s law in China: Bank branching regulation and window dressing," Journal of Empirical Finance, Elsevier, vol. 74(C).
    • Handle: RePEc:eee:empfin:v:74:y:2023:i:c:s0927539823001019
    DOI: 10.1016/j.jempfin.2023.101434
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    Keywords

    Goodhart’s law; Window dressing; Provision coverage ratio; Loan loss provisions; Deregulation; Branching;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting

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