Accounting Values versus Market Values and Earnings Management in Banks

Abstract

Banks worldwide are subject to increasing regulation and, simultaneously, find themselves under the close scrutiny of market analysts and screening of large institutional investors. Banks are required to maintain minimal equity relative to both total and risky assets, market analysts expect banks to grow at a certain rate and to show reasonable returns on assets and on equity.

Capital requirements imposed by central banks on commercial banks follow the guidelines of the BIS (Bank for International Settlement). These requirements are calculated and expressed in accounting terms, and not in terms of market value. The accounting literature is extensive on the issue of earnings management and there is substantial evidence that firms exploit different methods to smooth reported earnings and create hidden reserves that can later be translated into equity at some point in the future.

The question arises as to the extent capital adequacy regulations on the one hand, and expectations concerning banks' profits on the other, create incentives for banks to hide earnings in good times (by under-stating equity) and increase reported earnings in bad times. A model is developed mapping the optimal behavior of a bank operating in an uncertain environment that attempts to maintain capital requirements and meet target growth rates, while building a reservoir of hidden earnings for capitalization in future bad periods. It is shown that if banks are penalized for downward deviations from targets, while not being symmetrically rewarded for over-achieving, there will be incentives to create hidden reserves.

Keywords: earnings management, banks, book values, market values, capital requirements

JEL Classification: G18, G21, G28, F32, M41, M43