Earnings Conservatism and Litigation Exposure in the Banking Industry

Abstract

This paper examines the effect of managers’ liability exposure on earnings conservatism in the banking industry. Focusing on a wide international sample of commercial banks and using TIER1 as a proxy of bank managers’ exposure to litigation, our results show a negative relationship between the level of TIER1 and earnings conservatism. We interpret these results as evidence of an increase in bank managers’ liability exposure increasing earnings conservatism. Moreover, we find that this negative relationship holds for both, those banks with a TIER1 below the median country level of TIER1 (low-TIER1 banks) and those with a TIER1 above the median country level of TIER1 (high-TIER1 banks), even though it is less pronounced for the former group. Thus, although it is expected that higher public scrutiny scenarios in the banking industry (low-TIER1 banks) trigger a higher degree of unconditional conservatism, they do not prevent managers from resorting to earnings conservatism in an attempt to minimize not only litigation costs but also the likelihood of adverse political action.

Keywords: Commercial Banks, Capital Adequacy, Earnings Conservatism, TIER1, Panel Data Analysis

JEL Classification: G21, G28, M4, D4