The effect of leverage and liquidity on earnings and capital management: Evidence from U.S. commercial banks

Abstract

Prior research shows that firms can manage earnings aggressively through making accounting choices affecting discretionary current accruals surrounding equity offerings as a means of smoothing earnings over time. Some evidence indicates that aggressive earnings management carries over to aggressive management of capital structure in the form of higher leverage and aggressive management of working capital in the form of lower liquidity. Earnings management by banks is achieved instead by managing accruals dealing with payment behavior on loans: the loan loss provision and net charge-offs. A regulatory change expressed in the Basel III accords has tightened requirements on leverage and liquidity and could have affected earnings and capital management.This study examines the effect of leverage and liquidity on the behavior of earnings and capital management in U.S. commercial banks over the period from 1999 to 2013. If aggressive earnings management behavior carries over to aggressive leverage and liquidity policies, we should expect a negative relation between earnings management measures and capital measures and a negative relation between earnings management and liquidity measures. We show that earnings and capital management measures consistently have a significant positive relationship with capital ratios and a significant negative relationship with liquidity ratios. These results suggest that regulators should be on guard for all forms of aggressive management behavior. In the post-crisis period, our results also show evidence of additional regulatory scrutiny with a significant positive relation between liquidity and earnings management, which could indicate that less liquid banks are prevented from engaging in earnings management by regulators.