Economic Policy Uncertainty, Monetary Policy Uncertainty, and Bank Earnings Opacity

Abstract

Using a sample of U.S. banks and indices for economic policy uncertainty and monetary policy uncertainty developed by Baker et al. (2016), we investigate whether these two sources of policy uncertainty affect bank earnings opacity. When economic and monetary policies are relatively uncertain, it is easier for bank managers to distort financial information, as unpredictable policy changes make assessing the existence and impact of hidden “adverse news” more difficult for external stakeholders such as investors and creditors. 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 and monetary policy are 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 and monetary policy uncertainty lead to greater earnings opacity. We also find that the impact of policy uncertainty on financial reporting distortion is less pronounced for stronger banks (i.e., banks with high capital ratios).