Mitigating Bank Earnings Management - The Role of Regulation and Supervision

Abstract

This paper analyzes whether differences in bank earnings management across countries can be linked to differences in the prevailing institutional and regulatory framework. Using a broad sample of 21,895 banks from 47 countries over the period 1990 to 2006, we consider three dimensions along which insiders can exercise their discretion to manage reported earnings: loss avoidance, income smoothing and earnings aggressiveness. We develop a measure for each of these three dimensions of bank earnings management per country and then combine them to obtain a measure of overall bank earnings management. We then examine whether and to what extent our bank earnings management measures are related to the restrictiveness of bank regulations and the degree of official and private s in a country. The results confirm our hypotheses. Our measure of overall earnings management is decreasing in the restrictiveness of bank regulations and the extent of official supervision. The biggest contribution to a reduction in overall earnings management, however, stems from private monitoring. The findings for our individual earnings management measures broadly corroborate those of our overall measure. An explorative ownership analysis further reveals that the propensity for bank earnings management is also dependent upon ownership form.