In this study, we explore the hedge fund activist (HFA) influence on managerial decisions in the opaque banking industry. Focusing on loan loss provisions (LLPs), an accounting item that is subject to considerable managerial discretion as well as scrutiny from various regulatory agencies, we find that HFAs alleviate the agency problems associated with bank loan loss provisioning decisions. The findings show that HFA influence leads to a substantial reduction in overstatements, but not understatements, of LLPs at target banks. This results in a prompt increase in bottom-line profitability and stock returns, while pointing to no appreciable change in bank risk. We conclude that the disciplinary effect of HFAs contributes to shareholder value by leading to a reduction in excessive loan loss provisioning consistent with a realignment of LLP decisions with target bank shareholders’ interests.

ABSTRACT We estimate a structural model of bank portfolio lending and find that the typical U.S. community bank reduced its business lending during the global financial crisis. The decline in business credit was driven by increased risk overhang effects (consistent with a reduction in the liquidity of assets held on bank balance sheets) and by reduced loan supply elasticities suggestive of credit rationing (consistent with an increase in lender risk aversion). Nevertheless, we identify a group of strategically focused relationship banks that made and maintained higher levels of business loans during the crisis.