This study investigates the impact of earnings management on the efficiency of Eurozone banks, examining its chronological evolution until the implementation of International Financial Reporting Standard 9. Using data on 70 banks, we find that earnings management, defined as discretionary loan loss provisions, negatively affects efficiency. Meanwhile, when we also include non-discretionary provisions (those required by legal obligations), we estimate a positive impact of loan provisions on allocative efficiency—contrarily to a negative effect of discretionary provisions. This finding helps stress the importance of adequately defining earnings management, namely for the purpose of analyzing its effect on banking efficiency.
The 2008 financial crisis showed that well-managed banks are crucial to the smooth functioning of the business fabric, as they promote the efficient allocation of resources in the economy (Pathan and Faff, 2013). However, efficiency is not achieved if institutions are involved in activities that compromise their integrity and that of the sector (Ujah et al., 2017). One example of these practices, identified in the literature as one of the motives behind the 2008 financial crisis, was the occurrence of less transparent earnings management (Alhadab and Al-Own, 2019) through, for instance, the creation of excessive loan loss provisions (LLP), by reserving financial resources beyond those deemed reasonable to deal with credit risk and the associated danger of default by borrowers.
The relationship between earnings management and bank efficiency has received little attention in the literature. To the best of our knowledge, the few studies on the subject are the papers by Ab-Hamid et al. (2018); Martens et al. (2021) and Wu et al. (2016). Using either Data Envelopment Analysis (DEA) (Wu et al., 2016) or Stochastic Frontier Analysis (SFA) (Ab-Hamid et al., 2018; Martens et al., 2021), these studies show that excessive LLP adversely impact the efficiency of banks. The justification for this negative effect stems from the fact that excessive LLP prevent banks from efficiently transforming their inputs (e.g., capital, labor, and deposits) into outputs (e.g., loans and investments). Furthermore, directors may not practice adequate controls and monitoring, thereby conditioning efficiency (“bad management hypothesis” proposed by Berger and DeYoung, 1997). However, other studies suggest that LLP could increase efficiency, as a high volume of provisions can be part of the bank’s strategy because directors do not spend enough resources on credit risk (“skimping hypothesis” proposed by Berger and DeYoung (1997).
This study investigates the impact of earnings management on the efficiency of Eurozone banks, examining its chronological evolution until the implementation of International Financial Reporting Standard 9. Our results suggest that the greatest source of cost inefficiency comes from allocative reasons, or equivalently, that inefficiency owes more to incorrect choice of inputs than to underutilization/waste of resources. Regarding the impact of earnings management on efficiency, results suggest that the relationship between earnings management, measured through discretionary provisions (RD and RDS), and all efficiency scores (CE, TE, and AE) follows an inverted U-shaped form. However, we find a positive estimate of the impact of LLPTL on AE.