Unintended Costs of a Dual Regulatory Environment: Evidence from State-Level Cannabis Legalization and Bank Audit Fees

Abstract

Since 2014, a number of U.S. states have legalized business activities related to the production, distribution, and use of recreational cannabis. These activities remain illegal at the U.S. federal level, creating a dual regulatory environment. The uncertainty related to the enforcement of federal cannabis laws affects businesses located in legalizing states, particularly federally-insured banks. Applying a difference-in-differences approach to a matched sample of banks in legalizing and non-legalizing states, we document an increase in audit fees incurred by banks located in legalizing states after cannabis legalization. This finding is consistent with increased auditor effort and engagement risk being an unintended consequence of state-level recreational cannabis legalization. In supplemental analysis, we find that the relation between banks’ audit fees and cannabis legalization was greater for banks having larger increases in banking activity, suggesting that audit fees increased primarily for banks that may be engaging in relationships with cannabis-related businesses.

Keywords: Audit fees; Banking; Cannabis legalization; Conflicting regulatory environment; Enforcement uncertainty

JEL Classification: G28, M42, M48