The effect of decreasing interest rates on European banks’ earnings quality

Abstract

Earnings quality (EQ) is an indicator generally defined as a mix of many components like persistence, predictability, volatility and smoothing of earnings. This study is based on the hypothesis that in the banking sector, any changes in interest rates make a remarkable effect on these characteristics of earnings, and thus may influence EQ. Between 2007 and 2015, there has been a general decreasing trend in interest rates across Europe, with varying slopes in different countries. Using data of 128 European banks from 27 countries, it is examined how the extent of interest rate decrease influenced the EQ of banks. It was found that the extent of interest decrease negatively affects earnings quality, meaning that the EQ of banks located in countries with less drastic relative interest cuts between 2007 and 2015 (typically less developed Central and Eastern European countries) is higher than the EQ of banks from developed countries with significant relative interest cuts in the same period.