Government Guarantees and Banks' Earnings Management

Abstract

This paper examines the effect of government guarantees on banks’ loan loss provision smoothing. In our first setting we examine the direct reduction of government guarantees previously granted to a specific class of German banks known as the Landesbanken. Using a difference-in-difference design, we find an increase in earnings management via loan loss provision smoothing following the removal of explicit government guarantees. In our second setting we consider the creation of the Eurozone in 1999 as a positive shock to the relative importance of member countries’ banking system, suggesting an increase to banks’ implicit government guarantees. Similar to our first analysis, our results suggest that increasing government guarantees is associated with a statistically and economically significant reduction in banks' loan loss provision smoothing. These results also persist using a differences-in-differences framework considering banks from countries not affected by the monetary union as controls and after controlling for macro and bank specific variables that were contemporaneously affected by the Euro adoption. Overall, our findings highlight the role of government guarantees as a significant and economically important determinant of banks’ financial reporting behavior.