Does lower financial stability influence the banks’ earnings management? The role of enforcement

Abstract

We investigate the relationship between financial stability and bank earnings management (EM), moderated by enforcement quality. We use a sample of 828 listed commercial banks across 72 countries from 2000 to 2023 and employ linear regression with a high-dimensional fixed-effects estimator in our analysis. We find a positive and economically relevant effect of lower financial stability on the increase in bank engagement in EM through discretionary loan loss provisions. Furthermore, we find that banks operating in higher enforcement-quality environments are less likely to engage in discretionary loan-loss provision practices, suggesting that incentives to manage earnings decrease due to the likelihood of sanctions for poor financial reporting quality. Our results also demonstrate that enforcement quality negatively moderates the relationship between lower financial stability and EM. Our findings extend previous studies that treated financial stability or enforcement quality as isolated factors and provide new evidence for a worldwide sample, whereas many prior studies have focused on specific regions. Our findings suggest that regulators and policymakers seeking to enhance earnings quality in the banking industry should consider that enforcement quality can help mitigate opportunistic EM, particularly in financially unstable banks. Furthermore, our results highlight the relevance of considering institutional differences in enforcement quality when formulating worldwide banking regulations. In addition, our results could be useful to investors analyzing bank financial statements, particularly for commercial banks with lower financial stability operating in countries with weak enforcement environments.