Earnings Smoothing and Systemic Risk in the Banking Industry

Abstract

This study examines relations between earnings smoothing through loan loss provisions and a bank’s contribution to systemic risk in the banking industry. We find that earnings smoothing is negatively associated with a bank’s contribution to systemic default risk and systemic crash risk, consistent with the argument that a bank’s earnings smoothing mitigates its negative shocks to other banks and reduces informational and pure contagions. Moreover, earnings smoothing is negatively associated the contribution to systemic risk by larger magnitude for banks with higher earnings informativeness, lower earnings volatility, higher capital ratio, and during non-crisis periods. The evidence suggests that the mitigating effects of earnings smoothing operate via earnings informativeness and perceived business risk channels, and are weakened by tendency to manage capital and financial crisis. This study contributes to earnings smoothing, financial reporting quality and financial crisis literatures and has direct policy implications.