UC study analyzes 70 European banks and warns of the impact of earnings management on banking efficiency
Data from 70 of the 117 banks supervised by the European Central Bank were analyzed, including two Portuguese banks.
According to a study conducted by a team from the University of Coimbra (UC), the way in which earnings management (profits or losses) takes place using loan losses, which stem from the value judgments of bank administrators, can negatively affect banking efficiency. This research also underlines the importance of disclosing this information by banking entities in their annual reports and accounts, as well as carrying out internal and external audits of credit risk.
Using data from 70 of the 117 banks supervised by the European Central Bank (ECB), Catarina Proença, Mário Augusto and José Murteira, researchers at the Center for Research in Economics and Management (CeBER) and professors at the Faculty of Economics of the University of Coimbra (FEUC) , conducted this analysis with a view to deepening the effect of earnings management on banking efficiency. The study analyzed data from 2013 to 2017, the preparatory period for the implementation of the International Financial Reporting Standard 9 (IFRS 9) accounting standard, which establishes the criteria for recognizing and measuring credit impairments and which replaced the International Accounting Standard 39 (IAS 39 ), which proved to be ineffective, particularly in the context of the 2007 financial crisis.
Earnings management at banks is measured through discretionary credit impairments, which are defined by decision of directors, and non-discretionary credit impairments, which result from legislation or regulations in force. «Although they are legal, discretionary credit impairments can deviate from the spirit of accounting standards, which is reflected, for example, in the private information on expected credit losses, to which bank administrators have access», elucidate the authors.
The study shows that moderate or high levels of discretionary impairments are related to three main factors: «1) the existence of low quality loan portfolios in the analyzed banks increases the costs of monitoring and executing loans, which negatively influences its efficiency; 2) the creation of impairments in a non-regulatory manner negatively affects confidence in the banking sector and, consequently, its efficiency; 3) the boards of directors of banks do not seem to practice proper monitoring and appropriate controls for credit risk», highlight the authors of the study. When the level of these loan losses is low, banking efficiency is positive, «which may mean that administrators decide not to spend enough resources on credit risk analysis (for example, they decide not to have enough human resources for the volume of credit existing new or do not comply with internal regulations on credit risk in an intransigent manner), which immediately increases the degree of efficiency», the researchers advance.
The researchers explain that «a bank is efficient when it maximizes its results (outputs) using resources (inputs) that are limited». In the analysis carried out by the research group at the UC, total loans, liquid assets and other assets that generate income were considered as results; and as resources, interest, personnel expenses and operating expenses were considered.
The management of bank earnings related to discretionary loan impairments becomes particularly relevant in times of crisis, «which may lead to less transparent earnings management practices with the aim of mitigating unsatisfactory earnings or smoothing high earnings (the constitution of more impairments than the regulatory ones is a cost for the bank, which reduces its results), which compromises the efficient allocation of resources in the Economy», contextualize the authors.
The study included data from two Portuguese banks, Banco Comercial Português, S.A. (BCP) and Caixa Geral de Depósitos, S.A. (CGD). In terms of banking efficiency, in 2013, in the list of the 70 European banks analysed, these banks were ranked 56th and 53rd, respectively. In 2017, there was a significant improvement in the efficiency of these banks, with them occupying the 30th and 32nd positions. Analyzing the resources used in the calculation of efficiency, it appears that the interest paid in this period decreased by around 74%, in the case of BCP, and 61% in the case of CGD, and personnel costs by 32%, for BCP, and 17% for CGD. The scenario experienced between 2013 and 2017, of lower interest rates and employee layoffs, explains this escalation of efficiency positions in the 70 European banks.
Regarding the larger-scale impacts of this type of banking analysis, «in a new period of crisis such as the one we are currently experiencing, the importance of regulation and supervision of the banking sector, by the regulator, the supervisor and also by civil society, is emphasized », underline the professors of the UC Faculty of Economics. The investigation also sheds light on other elements that should be considered in an analysis of banking efficiency in the future, such as, for example, «the degree of political connections of the members of bank boards of directors», highlights the research team.
The scientific article “The effect of earnings management on bank efficiency: Evidence from ECB-supervised banks” is published in the journal Finance Research Letters, and is available here.
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