We exploit staggered state-level shocks to third-party auditor legal liability in the U.S. to test whether auditor litigation risk affects client companies' access to private debt markets. We find that an exogenous increase in auditor litigation risk leads to an increase in both clients' likelihood of receiving bank loans and the average amount of the bank loans that clients receive. In support of our proposed mechanism that auditor litigation risk leads to improvements in clients' audit and financial reporting quality, we find that these same shocks lead to a reduction in accruals, an increase in going-concern opinions, a decrease in restatements, and an improvement in accruals' ability to predict future cash flows. We also find that increased auditor litigation risk leads to an increase in the contractibility of clients’ accounting numbers, as proxied by the use of debt covenants, and a decrease in the cost of borrowing.

ABSTRACT We examine how regulatory restrictions on capital market activity affect the compensation contracting environment within firms. This study aims to expand our understanding of how financial market development affects firm risk‐taking via management compensation designs. Specifically, taking advantage of the staggered implementation of the Interstate Banking and Branching Efficiency Act (IBBEA), which increases bank competition and loan geographical diversification, this study examines how borrowing firms' compensation structures change when banks increase risk tolerance in their loan portfolios. Using hand‐collected compensation data of firms with market capitalization less than $75 million, we hypothesize and find that borrowing firms are likely to increase risk incentives after IBBEA and that this increase is more pronounced for firms located in states with less banking competition in the pre‐IBBEA period. We also show the findings to be more significant for borrowers whose lenders acquire more diversification benefits after IBBEA. These findings suggest that following deregulation, when banks face increased competition as well as an enhanced ability to diversify their credit risk geographically, these same banks tend to increase their tolerance for borrowers' risk‐taking. That is, their clients—nonfinancial firms borrowing from them—adjust their compensation contracts that are previously constrained by bank distaste for risk. We also document that firms that increase their risk incentives the most invest more in R&D, suggesting that management compensation is a complementary channel through which IBBEA affects firm innovation.