Does the Speculative Use of Derivatives and Audit Quality Affect the Cost of Debt in the Banking Industry?

Focusing on depositors, we first examine the relation between the use of speculative trading derivatives and the cost of debt capital of publicly-traded, bank-holding companies (BHCs). Secondly, we investigate whether audit quality mitigates any debt risk premium charged to BHCs that use trading derivatives. We find that uninsured depositors are more likely than are insured depositors to impose depositor discipline on BHCs that engage in the use of trading derivatives. We also find that higher quality audits reduce the risk premium for trading derivatives that uninsured depositors demand. The findings of this study contribute to the existing literature by furthering our understanding of incentives driving the necessity for audit quality. Our findings may be useful to bank regulators in evaluating the effectiveness of federal deposit insurance, bank managers in considering optimal funding sources, and investors in evaluating corporate risk management.