Economic policy uncertainty and bank earnings opacity

Abstract

Using a sample of U.S. banks and an index for economic policy uncertainty developed by Baker et al. (2016), we investigate whether economic policy uncertainty is systematically related to bank earnings opacity. When economic policy is relatively uncertain, it is easier for bank managers to distort financial information, as unpredictable economic policy changes make assessing the existence and impact of hidden “adverse news” more difficult for investors and creditors. Economic policy uncertainty also increases the fluctuation in banks’ earnings and cash flows, thus providing additional incentives and opportunities for bank managers to engage in earnings management. Our results show that uncertainty in economic policy is positively related to earnings opacity, proxied by the magnitude of discretionary loan loss provisions and the likelihood of just meeting or beating the prior year’s earnings, and negatively related to the level of accounting conservatism (i.e., the timeliness of recognition of bad news relative to good news). Collectively, our results suggest that economic policy uncertainty leads to greater earnings opacity. We also find that the impact of economic policy uncertainty on financial reporting distortion is less pronounced for stronger banks (i.e., banks with high capital ratios).