Income Smoothing Monitoring Mechanism

Journal of International Accounting, Auditing and Taxation 43 (2021) 100385
Contents lists available at ScienceDirect
Journal of International Accounting,

Auditing and Taxation
Income smoothing in European banks: The contrasting effects of

monitoring mechanisms
Costanza Di Fabio ⇑, Paola Ramassa, Alberto Quagli
University of Genoa, Department of Economics and Business Studies, Via Vivaldi 5, 16126 Genoa, Italy
a r t i c l e i n f o a b s t r a c t
Article history: This study provides evidence of the combined effect of various monitoring mechanisms on
Available online 16 March 2021 income smoothing through loan loss provisions using data on European banks across 25
countries and covering 2003 to 2015. We find that prudential supervision increases bank
Keywords: income smoothing, consistent with the idea that strict supervision increases banks’ incen-
Earnings management tives to signal business stability by managing earnings. However, the effect of prudential
Banks’ loan loss provisions supervision is conditional on the intensity of market discipline and accounting enforce-
Income smoothing
ment, which reduce income smoothing only in strict supervisory regimes. The analysis also
Institutional factors
Prudential supervision
takes into account the effectiveness of prudential supervision, measured by considering the
Accounting enforcement powers of national regulators and the results of financial health checks performed by
European Union regulators. The results show that the effectiveness of prudential supervi-
sion influences how other monitoring mechanisms constrain bank income smoothing.
Accounting enforcement reduces bank smoothing only in countries where prudential
supervision is effective. Our findings suggest that strengthening investors’ governance
and improving coordination between prudential supervisors and accounting enforcers
can limit the paradoxical effect of strict supervision, which reduces bank transparency if
not adequately combined with other monitoring mechanisms.
Ó 2021 Elsevier Inc. All rights reserved.
1. Introduction
The monitoring of banks’ financial reports involves investors, accounting enforcers, and prudential supervisors due to
banks’ critical intermediation function in national and global economies (Lobo, 2017; Lassoued, Attia, & Sassi, 2018). In the-
ory, regulators’ activity should safeguard – and even increase – financial reporting transparency, as accounting numbers con-
stitute the foundation of the firm-specific information set and enable effective monitoring (Bushman & Williams, 2012). For
this reason, prudential supervisors should oppose accounting manipulation to enhance transparency, which is crucial for
investors and accounting enforcement as well.
The global financial crisis highlighted oversight bodies’ responsibility to ensure the transparency of banks’ financial
reports (Wade, 2007). The literature offers mixed results on this topic. Some evidence shows that prudential supervisors
do not necessarily promote financial reporting transparency, suggesting that strong monitoring might be insufficient to limit
manipulative bank practices (Caramanis, Dedoulis, & Leventis, 2015; Humphrey, Loft, & Woods, 2009). Prudential supervi-
sors seem to focus more on stability issues than on promoting transparency, therefore, tolerating banks’ aggressive account-
⇑ Corresponding author.
E-mail addresses: costanza.difabio@unige.it (C. Di Fabio), paola.ramassa@unige.it (P. Ramassa), quaglia@economia.unige.it (A. Quagli).
https://doi.org/10.1016/j.intaccaudtax.2021.100385
1061-9518/Ó 2021 Elsevier Inc. All rights reserved.
C. Di Fabio, P. Ramassa and A. Quagli Journal of International Accounting, Auditing and Taxation 43 (2021) 100385
ing practices for the sake of stability (Gray & Clarke, 2004). For this reason, regulators prefer that banks overestimate credit
losses in loan loss provisions (LLP) during booms to create hidden reserves for use in downturns (García-Osma, Mora, &
Porcuna, 2019). However, estimating expected losses is subject to a high level of discretion, which managers can easily
exploit for opportunistic earnings management (e.g. Cohen, Cornett, Marcus, & Tehranian, 2014; Kanagaretnam, Lobo, &
Yang, 2004). This anti-cyclical provisioning reduces bank-reported income during booms and increases it during bursts, thus,
hindering transparency.
This study joins the debate by investigating the effect of prudential supervision on bank earnings management and by
exploring its combined effect with two monitoring mechanisms: market discipline and accounting enforcement. The study
aims to shed light on how monitoring affects banks’ reporting quality, about which previous studies produced mixed results.
Prudential supervision seems to reduce banks’ earnings management (Fonseca & González, 2008), but strict supervision is
recently associated with greater earnings management and a reduced ability of LLP to predict future credit losses (García-
Osma et al., 2019; Gebhardt & Novotny-Farkas, 2011; Marton & Runesson, 2017). In addition, few studies examine the com-
bined effect of monitoring mechanisms on banks’ reporting quality (Dal Maso, Kanagaretnam, Lobo, & Terzani, 2018).
We examine how prudential supervision affects banks’ earnings management, particularly in combination with market
discipline and accounting enforcement, focusing on income smoothing through LLP. Our focus on income smoothing is suit-
able for studying the effect of prudential supervision given the regulatory preference for a provisioning system with smooth-
ing effects on earnings. Furthermore, bank managers’ use of income smoothing through LLP is widespread because it allows
them to easily hide the manipulation of provisions for complex loan portfolios, and smoothing reduces earnings variability,
which is a key signal of risk. Hence, income smoothing through LLP can mask excessive risk-taking and avoid attracting
supervisors’ attention due to unusually high or low earnings levels (Bushman, 2014; Flannery, Kwan, & Nimalendran,
2004; Morgan, 2002). Additionally, this provisioning strategy is apparently in line with prudential supervisors’ preference
for anti-cyclic provisioning, thus avoiding corrections and penalties while also creating a false impression of stability and
obscuring loan portfolios’ risks (Bushman, 2014; García-Osma et al., 2019; Peterson & Arun, 2018).
We test four hypotheses on the effect of prudential supervision on banks’ income smoothing using multivariate regres-
sions on a panel dataset comprising 217 banks from 25 European countries and covering 2003 to 2015 (totaling 811 bank-
year observations). The European setting is particularly interesting for our research objectives, for three main reasons. First,
the European Union (EU) has increasingly strengthened the supervisory function, which is necessary to ‘bolster the Union
[and] restore financial stability’ (EU Council, 2013). In the European vision, the role of national authorities has been decisive
in favoring the diffusion of a ‘common supervisory culture’ through the adoption of common practices and through active co-
operation with the European Central Bank (Lautenschläger, 2018).
Second, despite the efforts of European authorities, inconsistencies between national authorities’ approaches seem to per-
sist, as does supervisory leniency towards banks’ opaque behaviors (Agarwal, Lucca, Seru, & Trebbi, 2014; Fiordelisi, Ricci, &
Lopes, 2017). Therefore, the European context allows us to examine the differences among oversight bodies’ abilities to
improve transparency, thus, empirically challenging the assumption that supervision necessarily improves financial report-
ing quality (Caramanis et al., 2015; Humphrey et al., 2009).
Third, the EU setting enables us to explore the combined effect of various monitoring mechanisms, including prudential
supervision, market discipline, accounting enforcement, given that the considerable national differences between institu-
tional backdrops can affect the final output of the monitoring activity (Caramanis et al., 2015; Kaufmann, Kraay, &
Mastruzzi, 2013). We find that banks’ income smoothing is greater in strict prudential regimes, where regulators have a great
deal of power to impose penalties and corrections. As expected, in these regimes, income smoothing is constrained by mar-
ket discipline and the national accounting enforcement. Specifically, we reveal that accounting enforcement reduces bank
smoothing in countries where prudential supervision is effective. This happens in (i) countries with powerful prudential reg-
ulators who were able to prevent ex ante bank misreporting had few corrections during European supervisory reviews; and
(ii) countries with weaker national regulators, where supervision was effective due to the support of the European Central
Bank (ECB), which required ex-post corrections to bank figures.
These findings are consistent with the idea that strict prudential supervision increases banks’ incentives to manage earn-
ings in order to avoid close regulatory scrutiny by signalling business stability. Second, we find that the effect of supervisory
strictness on bank earnings management is conditional on the intensity of both market discipline and accounting enforce-
ment. On the one hand, market monitoring reduces smoothing, in line with the view that the market’s interest in reliable
financial reporting limits incentives to smooth earnings opportunistically. On the other hand, accounting enforcement
reduces smoothing, consistent with the view that incentives to manage earnings decrease due to the likelihood of incurring
sanctions for misreporting. This happens in contexts wherein accounting enforcers must intervene proactively to discourage
opportunistic accounting behaviors, particularly in countries with effective prudential supervision.
This study contributes to accounting research on how institutional factors affect the quality of banks’ financial reporting.
First, our findings enrich studies on the moderating role of regulatory factors in the complex relationship between prudential
supervision and income smoothing (García-Osma et al., 2019). Specifically, we provide evidence on the distinct effects of
monitoring by national supervisory authorities, accounting enforcers, and private investors. Our results suggest that in strict
prudential regimes, market monitoring and accounting enforcement complement prudential supervision supporting trans-
parency, which is crucial to monitor bank risk-taking (Stephanou, 2010).
Second, we extend the literature on accounting enforcement, which focuses on industrial firms, by providing evidence on
how accounting enforcement affects a highly regulated industry. We find that accounting enforcement has a positive effect
2
on banks’ accounting quality. Specifically, we show that enforcement counterbalances the negative effect of prudential
supervision on banks’ transparency in effective regimes.
Moreover, our findings add to the literature on the effects of bank regulations, lending further empirical support to the
view that increasing supervisory powers cannot improve bank behaviors and enhance transparency. Indeed, tightening the
powers of national supervisors negatively affects transparency, while enhancing accounting regulation can increase bank
reports’ quality and informativeness (Dal Maso et al., 2018; Duru, Hasan, Song, & Zhao, 2018).
The remainder of this paper is organized as follows. Section 2 reviews the relevant literature and develops the study’s
hypotheses. Section 3 outlines the empirical models used to test our hypotheses and describes the study’s sample, bank-
level data, and country-level measures used as proxies for institutional features. We provide the estimation results in Sec-
tion 4 and additional analyses in Section 5. Finally, Section 6 concludes the paper and discusses its policy implications.
2. Literature review and hypothesis development
2.1. Agency issues, information asymmetry, and income smoothing in banks
The banking industry has the crucial function of serving as financial intermediation between depositors and firms (bor-
rowers) but is also characterized by significant agency issues. Agency conflicts affect the relationship between bank man-
agers and fund providers – namely shareholders (the owner-manager agency problem) and depositors (the firm-creditor
agency problem) – as managers tend to engage in excessive risk-taking at the expense of these providers (Bushman, 2016).
These agency issues are fostered by information asymmetries arising from opacity in bank transactions and financial dis-
closures. The inherent opacity of banks’ businesses and the dispersion of fund providers prevent dispersed depositors and
shareholders from monitoring and controlling managers’ behaviors effectively (Beatty & Liao, 2014; Flannery et al., 2004;
White, 1990). Additionally, information asymmetry increases due to the limited information available to dispersed fund pro-
viders about the risks faced by the bank and the risk of losing their savings. In such a scenario, managers behave opportunis-
tically and engage in accounting manipulation to mask the accounting effects of risk-taking behaviors and influence fund
providers’ perceptions of the banks’ performance and managerial behaviors (Healy & Wahlen, 1999; Morgan, 2002;
Schipper, 1989). These manipulations impair the informativeness of the accounting information provided by financial state-
ments and reduce outsiders’ ability to monitor the bank (Fan & Wong, 2002; Leuz, Nanda, & Wysocki, 2003; Marquardt &
Wiedman, 2004).
Income smoothing is one of the most frequent manipulative behaviors in the industry. Typically, bank managers manip-
ulate accounting figures to smooth income over time, as a smooth earnings path masks excessive risk-taking by lowering the
business’ perceived risk. For instance, a stable earnings stream can support a higher level of dividends than with variable
earnings, with favorable effects on share value and investor perceptions (Beidleman, 1973). Managers can easily reduce earn-
ings fluctuations relative to fundamental performance by manipulating the main bank accrual, namely LLP (Barnea, Ronen, &
Sadan, 1976; Herrmann & Inoue, 1996; Karmon & Lubwama, 1997).1 Managers can exert considerable discretion on LLP given
the complexity of bank loan loss accounting flowing from the illiquidity of loan markets and the inherent intricacy of loan port-
folios (Acharya & Ryan, 2016; Becht, Bolton, & Röell, 2011; Leventis, Dimitropoulos, & Anandarajan, 2011).
In such an opaque setting, regulation aims to mitigate the negative outcomes of these agency issues through require-
ments concerning information disclosure, capital adequacy, and monitoring mechanisms. Supervisory bodies aim to protect
depositors and investors by limiting bank failures, thereby preventing systemic crises and safeguarding financial stability
(Barth, Caprio, & Levine, 2004; Flannery et al., 2004; Rochet, 2005).
Bank accounting information is subject to public and private enforcement mechanisms, including (i) prudential supervi-
sors (regulators), (ii) private investors, and (iii) accounting enforcers (Djankov, La Porta, Lopez-de-Silanes, & Shleifer, 2008;
La Porta, Lopez-de-Silanes, & Shleifer, 2006). Markets cannot take measures against banks and express a generic demand for
transparent information to facilitate their analyses and allow them to choose investments in line with their risk profile. By
contrast, prudential supervisors and accounting enforcers have coercive powers to address infringement, but also have dis-
tinct ultimate goals. Accounting enforcers aim to ensure transparency by verifying the compliance of financial information
with the applicable reporting framework (CESR, 2003), while prudential supervisors focus mainly on safeguarding financial
stability, paying particular attention to banks’ risks (Marton & Runesson, 2017). 2
2.2. Effect of strict prudential supervision on bank income smoothing
Regulators with a main focus on stability could motivate banks to alter reported earnings whenever reporting altered
accounting figures to supervisory bodies would be beneficial, as in other regulated industries (Burgstahler & Dichev,
1997; Shen & Chih, 2005). From this perspective, banks are particularly likely to employ smoothing strategies, as these (i)
allow managers to avoid close inspection from regulators due to unusually high or low levels of earnings and (ii) substan-
1
Instead, from an information enhancement perspective, smoothing constitutes an efficient signal used by managers to communicate private information to
the market, as it is easier for investors to predict future earnings from smoother earnings (Beatty & Harris, 1999; Dechow, Ge, & Schrand, 2010; Kanagaretnam,
Lobo, & Yang, 2005; Warfield, Wild, & Wild, 1995).
2
From their perspective, opaque accounting is just one of many risk indicators (Marton & Runesson, 2017).
3
tially match the preference of prudential supervisors for loan loss accounting (García-Osma et al., 2019; Gaston & Song,
2014; Lobo, 2017).
Supervisors consider loan loss accounting as a tool for limiting moral hazard problems with lenders, enabling the reten-
tion of earnings and avoiding pro-cyclicality (Beatty & Liao, 2011). Accordingly, they welcome the recognition of larger pro-
visions during boom periods, as this enables banks to create hidden reserves that serve as buffers against future credit losses
(Benston & Wall, 2005). This mechanism helps banks face periods of economic downturn by exploiting hidden reserves when
credit risk materialises and mitigates pro-cyclicality (Gray & Clarke, 2004; Jin, Kanagaretnam, & Liu, 2018). Income smooth-
ing through LLP produces results aligned with this approach, as it enables the covering of credit risk by creating hidden
reserves against expected losses in boom periods and the use of these reserves to cover losses in downturns.
The regulatory emphasis on financial stability and strong supervisory pressure on banks could represent a primary moti-
vation for banks to engage in smoothing practices (Peterson & Arun, 2018). The evidence supports this view by showing that
banks under tighter regulatory regimes engage in more income smoothing even after International Financial Reporting Stan-
dards (IFRS) adoption, suggesting that the reduction in the discretionary estimation of LLP induced by IAS (International
Accounting Standard) 39 has been weaker under stricter supervision (García-Osma et al., 2019; Gebhardt & Novotny-
Farkas, 2011).3
Thus, we argue that the extent to which national supervisory authorities have the power to inflict penalties on banks is
likely to influence the banks’ propensity to smooth income through LLP. By doing so bank managers signal stability, thus,
reducing the likelihood of sanctions for risky behaviors and supervisors’ corrections to the provisioning level. Therefore,
we expect banks under strict supervisors to smooth income more than banks under weak supervisory regimes in order to
avoid regulatory measures and sanctions. Accordingly, we posit the following:
H1: Strict prudential supervision is positively associated with banks’ income smoothing.
This prediction is in line with the banking research finding that strengthening the power of regulatory agencies can pro-
duce unintended effects on banks. In particular, studies reveal that strict supervision is associated with higher problem loans
(Barth et al., 2004), can reduce the integrity of bank lending behaviors (Beck, Demirgüç-Kunt, & Levine, 2006), and can jeop-
ardize the efficiency of the financial system (Shleifer & Vishny, 2002).
2.3. Moderation effect of market monitoring
Smoothing reduces accounting quality when banks exploit income smoothing to produce an impression of alignment
with supervisory goals and opportunistically reduce the perceived business risk (Ahmed, Neel, & Wang, 2013; Leuz et al.,
2003). This conflicts with the information needs of investors, who prefer transparent financial statements that enable them
to choose investments in line with their risk profile. Hence, smoothing leads to negative economic consequences, such as
poor investment decisions (García-Osma et al., 2019).
The research argues that market monitoring leads to a more efficient banking sector thanks to accurate information dis-
closure (Hay & Shleifer, 1998) and less bank corruption (Beck et al., 2006). Consistent with this view, sounder banks are
located in countries where financial data on banks must be reported regularly and accurately to market participants
(Demirguc-Kunt, Detragiache, & Tressel, 2008), suggesting that private investors’ monitoring can reduce reporting opacity.
From this perspective, market monitoring represents a mechanism of governance operating externally to banks through var-
ious channels (Stephanou, 2010), exposing managers to disciplining forces that could reduce managerial incentives to distort
financial reports. This view is in line with the diversion hypothesis (Leuz et al., 2003), which suggests that outsiders’ moni-
toring reduces managerial incentives to engage in earnings management, and is also consistent with the evidence that mar-
ket monitoring reduces banks’ income smoothing (Fonseca & González, 2008).
Accordingly, we argue that market monitoring is likely to counterbalance the effect of supervisory strictness; thus, market
discipline is likely to reduce income smoothing under powerful supervisors, where incentives to smooth income increase.
Consequently, we formulate our second hypothesis as follows:
H2: Market monitoring reduces bank income smoothing under strict prudential supervision.
2.4. Moderating effect of accounting enforcement
Government-authorized or -appointed enforcement bodies at the national level typically4 carry out accounting enforce-
ment to detect irregularities in companies’ financial reporting (Quagli & Ramassa, 2018; UNCTAD, 2017) and impose penalties
in the case of infringement (Brown, Preiato, & Tarca, 2014; CESR, 2003).
Cross-country studies document the positive effect of accounting enforcement on the quality of financial information
(Ball, Kothari, & Robin, 2000; Ball, Robin, & Wu, 2003; Leuz et al., 2003; Burgsthaler, Hail, & Leuz, 2006) and show that
for non-financial firms the benefits of IFRS adoption are greater under stronger enforcement (Christensen, Hail, & Leuz,
3
However, the literature is not unanimous on this point. Studies using international samples reveal a reduction in bank income smoothing for countries with
stricter supervision regimes (Fonseca & González, 2008).
4
In line with chapters 4 and 5 and Article 299 of the European Treaty, European accounting enforcement authorities operate at the level of each Member
State.
4
2013; Daske, Hail, Leuz, & Verdi, 2008; Florou & Pope, 2012; Li, 2010).5 Enforcement also reduces earnings management by
IFRS firms and increases the timely loss recognition of goodwill and the quality of financial disclosure (Glaum, Landsman, &
Wyrwa, 2018; Glaum, Schmidt, Street, & Vogel, 2013; Houqe, van Zijl, Dunstan, & Karim, 2012).
This literature focuses on industrial firms, which are less-regulated and subject to fewer monitoring mechanisms than
banks. Only recently has research directly studied the effect of accounting enforcement on banks’ earnings quality, finding
that enforcement seems to reduce managerial discretion in estimating LLP and earnings management to avoid losses (Dal
Maso et al., 2018). In addition, the informativeness of banks’ financial statements seems higher in countries with stricter
bank accounting regulations (Duru et al., 2018).
The research has also started to define the mutual role of accounting and non-accounting regulations in disciplining over-
sight on banks, revealing that non-accounting regulation enhances the effects of accounting enforcement on banks’ earnings
quality (Dal Maso et al., 2018). However, these results are obtained by combining three distinct components – the strictness
of prudential supervisors, restrictions on bank activities, and the intensity of market monitoring – into a single measure of
banking regulation, even if they might produce different effects on banks’ accounting behaviors.
We focus on prudential supervision and argue that rigorous accounting enforcement, the ultimate goal of which is pre-
serving financial reporting transparency, discourages banks from manipulating earnings. Therefore, accounting enforcement
is likely to reduce banks’ income smoothing, thus, contrasting with the effect of strict prudential supervision. Accordingly,
we hypothesise the following:
H3: Accounting enforcement reduces bank income smoothing under strict prudential supervision.
To refine this hypothesis, we also consider that enforcement outcomes are not straightforward. Indeed, research casts
doubts on the actual desirability of enforcement, finding that strengthening enforcement can reduce shareholder wealth
(Christensen, Liu, & Maffett, 2020) and produce significant compliance costs, such as audit effort, risk, and fees (Florou,
Morricone, & Pope, 2020). In the United States (US), the likelihood of enforcement actions also significantly increases the
need for shareholders to bear the costs of monitoring agents (Leventis, 2018).
Furthermore, it is not clear whether enforcers are proactive in identifying and correcting reporting irregularities, as they
have largely reacted to other parties’ actions (Christensen et al., 2020).6 Other factors can also work in a complementary way.
For instance, enforcement and audit might act as complementary monitoring mechanisms, as suggested by the audit pricing
increases for firms with greater prominence on the US Securities and Exchange Commission’s (SEC’s) radar (Leventis, 2018).
Given this complexity, the effects of national accounting enforcement on bank behaviors can be best explained by con-
sidering the banking industry as a complex setting, in which the goal of financial stability prevails over the need for trans-
parent financial reporting. In such a scenario, accounting enforcers are likely to intervene proactively against opportunistic
behaviors, particularly when prudential supervision is effective in maintaining bank stability (Donzé, 2006; Quintyn &
Taylor, 2003).
Supervisors can also stress the importance of transparency in preserving stability based on the idea that transparent
financial reporting enables the proper monitoring of bank risk-taking (Bushman, 2016; Cordella & Yeyati, 1998; Rochet,
1992; Stephanou, 2010). Supervisory culture informed by transparency produces positive effects on banks’ financial reports;
as a result, regulators are likely to make few corrections to banks’ reported numbers during their reviews. Supervisors can
also be effective by carrying out frequent inspections (as are performed by European authorities) to verify banks’ information
reliability, correct bank numbers, and apply sanctions for misbehavior.7
In contexts characterized by effective supervision, for two reasons accounting enforcers are likely to work proactively to
reduce opportunistic bank behaviors. First, their activity is aligned with the prudential supervisors’ stress on transparency,
which is seen as a necessary complement to stability by powerful regulators. Second, irregularities are likely to emerge dur-
ing supervisory reviews in countries where regulators are effective in imposing ex-post corrections.
Accordingly, we hypothesize that accounting enforcement reduces income smoothing in countries with effective super-
vision. Thus, we formulate the following:
H3.a: Supervisory effectiveness affects the impact of accounting enforcement on banks’ income smoothing.
3. Research design
We describe the sample and data used to empirically test our predictions in Section 3.1 and outline the study’s economet-
ric models in Section 3.2. Section 3.2.1 presents the basic model used to detect smoothing, and Section 3.2.2 describes the
models used to test the effect of institutional features (i.e. the effect of prudential supervision and the moderation effects of
market monitoring and national accounting enforcement).
5
The benefits are in the value-relevance of financial reporting, liquidity, analyst following, and a reduction in the cost of capital.
6
See also Brown and Tarca (2007).
7
This is particularly the case when national regulators have no power to diffuse ex ante the importance of transparency but are nevertheless supported by
European authorities in performing health checks on supervised banks (BCBS, 2002, 2006; Delis & Staikouras, 2011).
5
3.1. Data
We test our predictions on an unbalanced panel dataset, as panel data enable us to control for the effects of intertemporal
dynamics as well as for unobservable heterogeneity among sampled banks, which enables an overall control for the impact
of omitted variables. The population consists of 1,103 listed and non-listed banks from the EU (EU28) included in the BankS-
cope database. Considering data from consolidated financial statements covering 2003 to 2015, we obtain 14,339 bank-year
observations,8 but due to missing values (see Appendix 1) our final sample is 217 banks and 811 bank-year observations from
25 European countries.
We employ data on the gross domestic product (GDP) of European countries extracted from World Bank databases and
construct three institutional variables to examine the effect of prudential supervision, market monitoring, and accounting
enforcement on bank income smoothing (see Appendix 2). We construct variables reflecting the strictness of prudential
supervision and the intensity of market monitoring by building on the World Bank’s dataset on banking regulation and
supervision by Barth, Caprio, and Levine (2008, 2013). This dataset represents the most complete and authoritative dataset
designed ad hoc for the industry and is widely used by research in the field (e.g. Fonseca & González, 2008; Gebhardt &
Novotny-Farkas, 2011; Kanagaretnam, Lim, & Lobo, 2014; Marton & Runesson, 2017; Dal Maso et al., 2018). We employ data
drawn from Survey III (Barth, Caprio, & Levine, 2008) covering 2003 to 2010 and data taken from Survey IV (Barth, Caprio, &
Levine, 2013) covering 2011 to 2015.
The Official Supervisory Power Index provided by this dataset expresses the extent to which national supervisory author-
ities have the power to obtain information from banks and to undertake corrective action and penalties. In other words, it
measures the degree to which the national supervisor has the authority to take specific action. SUPERVt is our dummy vari-
able for the strictness of prudential supervision. We define prudential supervision in a country as ‘strict’ and SUPERVt equals
1 when the Official Supervisory Power Index is above the sample median, and otherwise consider supervision ‘weak’ and code
SUPERVt as 0.
Our proxy for the ability of private investors to monitor banks’ behaviors and exert effective governance on them is
MARKETt, which is a continuous variable assuming the values of the Private Monitoring Index (Barth et al., 2008, 2013). This
index expresses the extent to which regulation enables investors to monitor banks’ behaviors through various channels, such
as international agencies ratings, mandatory disclosure, and directors’ legal liability for incorrect or misleading information).
Our proxy for the country-level intensity of accounting enforcement is ENFORCEt, which is a continuous variable assuming
the values of the TOTAL Index developed by Brown et al. (2014). The index measures the degree of accounting enforcement
activity by national enforcement bodies and the quality of auditors’ working environment. It is measured at three points in
time: 2002, 2005, and 2008. We employ 2002 data for 2003 and 2004. We use 2005 data for the 2005–2007 period and 2008
data for the 2008–2015 period.9
Finally, we complement our analyses using the results of ECB financial health checks on European banks published after
the Comprehensive Assessment performed between 2013 and 2014 (ECB, 2014). We consider the corrections to TIER1 capital
and employ HIGH_CORRECTIONS, a dummy variable equal to 1 if the magnitude of the corrections made by the ECB to bank
TIER1 capital in a country is above the sample median and 0 otherwise.
Table 1 presents the values of the institutional characteristics measured through the indicators built by Barth et al. (2008,
2013) and Brown et al. (2014) for our sample countries. The values of the Official Supervisory Power Index used to build our
variable for prudential supervision strictness (SUPERV) are available for all 25 European countries. However, data for the Pri-
vate Monitoring Index are not available for Cyprus and Estonia. Therefore, we run models testing H2 on 758 observations. The
values of TOTAL Index are not available for Bulgaria, Cyprus, Estonia, Latvia, Lithuania, and Luxembourg. Consequently, we
test H3 on 673 observations. Finally, H3.a is tested using 529 observations because of the unavailability of data on correc-
tions to regulatory capital for Bulgaria, Czech Republic, Denmark, Hungary, Poland, Sweden, and the United Kingdom (UK).
The power of the prudential supervisor in Survey III is highest in Hungary, Lithuania, Malta, and Portugal, whereas it
reaches its lowest value in Italy. Slovenia exhibits the strongest prudential supervision in Survey IV, while market monitor-
ing is highest in the Netherlands in Survey III (exhibiting a lower score in Survey IV). The intensity of accounting enforcement
is highest in Denmark, France, Italy, and the UK.
3.2. Econometric models
3.2.1. Modeling banks’ income smoothing

In line with prior research on banks’ income smoothing, our empirical focus is on LLP, banks’ main accrual, which typi-
cally explains much of the variability in total accruals (Beatty & Liao, 2014). We measure income smoothing using a basic
multivariate regression model adapted from Kanagaretnam, Lobo, and Mathieu (2003) and Kanagaretnam et al. (2004),
which models the magnitude of LLP as a function of a set of explanatory accounting variables (see Appendix 3). We include
pre-managed earnings in the model and define bank smoothing propensity as the coefficient of pre-managed earnings; thus,
8
A 13-year timeframe is appropriate because it enables the modeling of income smoothing over time (Dechow et al., 2010). In addition, it enables us to study
the effect of monitoring on smoothing behaviors during a period characterized by evolving supervisory structures and bank business models.
9
In line with the literature, we employ the Brown et al. (2014) measure instead of other available proxies (e.g. La Porta et al., 1998; Christensen et al., 2013)
as it is a continuous index measuring the intensity of accounting enforcement rather than market regulations and law enforcement.
6
Table 1
Values of the indexes employed to build the institutional variables used in the analyses.
Country Barth et al. (2008, 2013) Brown et al. (2014)

Official Supervisory Power Private Monitoring Index AETOTAL Index
Index
Survey III Survey IV Survey III Survey IV 2002 2005 2008
Austria 10 12 6 8 17 26 27
Belgium 11 11 7 8 24 40 44
Bulgaria 11 11 7 8 – – –
Cyprus 12 11 – 9 – – –
Czech Republic 10 – 7 – 11 16 19
Denmark 10 11 10 8 27 49 49
Estonia 13 12 – – – – –
Finland 9 5 8 7 18 32 32
France 8.5 10 8 10 34 48 45
Germany 8 11 9 7 18 42 44
Greece 10 8 9 8 12 26 26
Hungary 14.5 13 9 8 15 17 18
Ireland 12 6 10 11 23 29 41
Italy 7 13 8 8 34 43 46
Latvia 10 12 9 7 – – –
Lithuania 14.5 11 10 7 – – –
Luxembourg 10 13 7 8 – – –
Netherlands 10.182 11 11 8 12 21 43
Poland 9 11 8 9 11 17 28
Portugal 14 12 7 6 16 26 29
Romania 11.667 12 6 7 9 11 15
Slovenia 14 14 8 7 17 19 19
Spain 12.5 9 9 9 19 35 42
Sweden 8 – 7 – 22 30 34
United Kingdom 8 – 10 11 32 54 54
Note: Details on the indexes employed to construct institutional variables used in the analyses are provided in Appendix 2 and 3.
a positive coefficient of pre-managed earnings expresses income-smoothing propensity. Managers engaging in income
smoothing increase LLP when pre-managed earnings are high and reduce provisions when unmanaged earnings are low.
The basic model used to detect banks’ income smoothing is as follows:
LLPi;t = b0 + b1 EBTP + b2 NPLOANS i;t1 + b3 DLOANS
i;t i;t + b4 LLA i;t1 + b5 CHOFF i;t1 þ b6 SIZEi;t
X
þ b7 REGC AP I;t þ b8 DGDP t þ b9 T t þ et ð1Þ
This model includes accounting variables expressing the non-discretionary component of provisions (Beatty,
Chamberlain, & Magliolo, 1995; Beaver & Engel, 1996; Kim & Kross, 1998; Wahlen, 1994). Specifically, we consider that
LLP should be explained primarily by the level of non-performing loans (NPLOANS i,t-1) held by the bank and expect a positive
sign of this variable, as an increase in NPLOANS implies an increase in credit risk and, consequently, higher provisions.
We also include variation in bank loans (DLOANS i,t), whose coefficient is expected to be positive, as an increase in loans
implies an overall higher credit risk and higher LLP (García-Osma et al., 2019; Gebhardt & Novotny-Farkas, 2011).
We further control for changes in riskiness by considering the beginning balance of the allowance for loan losses (LLA i,t-1)
and loan charge-offs (CH_OFF i,t-1). We expect positive coefficients for these variables, as higher allowances and increased
charge-offs are typical signs of higher riskiness, thus, leading to higher provisions (Greenawalt & Sinkey, 1988;
Kanagaretnam et al., 2004; Wahlen, 1994).
We also control for bank size (SIZE i,t) given that larger banks could have higher levels of business and are expected to
provide more for loan losses due to their increased activity and risk (Anandarajan, Hasan, & McCarthy, 2007). Accordingly,
we expect a positive coefficient for this variable.10
Furthermore, we consider capital management as another main determinant of LLP magnitude (Ahmed, Takeda, &
Thomas, 1999; Pinto & Picoto, 2018) by including REG_CAP i,t, which is the banks’ total regulatory capital ratio (Dal Maso
et al., 2018). Since banks are expected to maintain a certain total capital ratio, banks characterized by low ratios are likely
to manipulate them upwards by adjusting LLP in order to avoid the cost of violating prudential regulation (Curcio, De
Simone, & Gallo, 2017; Kim & Kross, 1998). The expected sign of the relationship between LLP and regulatory capital is
10
In line with Anandarajan et al. (2007), SIZE is calculated as the natural logarithm of total assets in year t. We obtain the same results when employing the
natural logarithm of total assets in year t-1, but using this variable reduces the number of observations from 811 to 554.
7
not a priori clear, as it depends on the combined effect of provisions on both Tier1 and Tier2 (Ahmed et al., 1999;
Anandarajan et al., 2007; Bouvatier & Lepetit, 2008; Fonseca & González, 2008; Pérez, Salas-Fumas, & Saurina, 2008).11
Finally, we include growth in national GDP (DGDPt) to control for the pro-cyclical effect of provisioning (Bikker &
Metzemakers, 2005; Fonseca & González, 2008; Laeven & Majnoni, 2003; Pérez et al., 2008). During booms, increasing
incomes reflect improvements in firms’ conditions and reduce the likelihood of loan defaults, so banks are expected to lower
provisions. Contrariwise, the likelihood of default increases during recessions, and consequently banks should increase their
provisioning levels. Therefore, we expect a negative relationship between DGDPt and LLP.
3.2.2. Testing effect of institutional features on banks’ income smoothing

We test how institutional features affect banks’ income smoothing following a procedure in line with research on the
effects of institutional factors on banks’ earnings quality. Then, we introduce double (H1) and triple (H2, H3, and H3.a) inter-
action terms that combine the institutional features under investigation (prudential supervision, market monitoring, and
accounting enforcement) and pre-managed earnings.
We test our hypothesis on the strictness of prudential supervision (H1) by running the following model:
LLPi;t = b0 + b1 EBTP i;t + b2 SUPERV t + b3 EBTP i;t * SUPERV t + b4 NPLOANS i;t1 + b5 DLOANS i;t
X
þ b6 LLAi;t1 þ b7 CHO FF i;t1 þ b8 SIZEi;t þ b9 REGC AP i;t þ b10 DGDPt þ b11 T t þ et ð2Þ
The interaction term is generated by interacting pre-managed earnings with the indicator variable SUPERVt. Its coefficient
expresses the effect of strict prudential supervision on banks’ income smoothing. Therefore, it is expected to be positive and
significant, as we hypothesize that banks’ income smoothing increases under strict prudential supervisors.
Before testing the moderation effect of market monitoring (H2), we run the following model to understand the single
effect of market monitoring on bank income smoothing:
LLPi;t = b0 + b1 EBTP i;t + b2 MARKET t + b3 EBTP * MARKET t + b4 NPLOANS i;t1 + b5 DLOANS
i;t i;t
X
The coefficient of the interaction term between MARKETt and EBTP i,t measures the influence of the external governance
exerted by private investors on banks’ income smoothing, and is expected to be negative and significant.
Our second hypothesis (H2) predicts that market monitoring reduces banks’ propensity to smooth earnings under strict
prudential supervisors. To test this prediction, we run model (4):
LLPi;t = b0 + b1 EBTP i;t + b2 SUPERV t + b3 MARKET t + b4 EBTP i;t * SUPERV t + b5 EBTP i;t * MARKET t
þ b6 SUPERV t MARKET t þ b7 EBTP i;t SUPERV t MARKET t þ b8 NPLOANSi;t1 þ b9 DLOANSi;t þ b10 LLAi;t1
X
þ b11 CHO FF i;t1 þ b12 SIZEi;t þ b13 REGC AP i;t þ b14 DGDPt þ b15 T t þ et ð4Þ
The coefficient of interest in model (4) is the coefficient of the interaction between EBTP i,t, SUPERVt, and MARKETt, which
expresses the degree to which market monitoring can mitigate banks’ income smoothing under strict prudential supervisors.
It is expected to be negative and significant, as we hypothesize that market monitoring reduces banks’ income smoothing
under strict prudential supervisors.
Before testing the moderation effect of accounting enforcement (H3), we run model (5) to identify the effect of accounting
enforcement on banks’ income smoothing:
LLPi;t = b0 + b1 EBTP i;t + b2 ENFORCEt + b3 EBTP * ENFORCEt + b4 NPLOANS i;t1 + b5 DLOANS
i;t i;t
X
The coefficient of the interaction between ENFORCEt and EBTP i,t is expected to be negative and significant.
Then, we run model (6) to test our third hypothesis (H3), which predicts that accounting enforcement discourages banks
from engaging in income smoothing in strict supervisory regimes:
LLPi;t = b0 + b1 EBTP i;t + b2 SUPERV t + b3 ENFORCEt + b4 EBTP i;t * SUPERV t + b5 EBTP i;t * ENFORCEt
þ b6 SUPERV t ENFORCEt þ b7 EBTPi;t SUPERV t ENFORCEt þ b8 NPLOANSi;t1 þ b9 DLOANSi;t þ b10 LLAi;t1
X
þ b11 CHO FF i;t1 þ b12 SIZEi;t þ b13 REGC AP i;t þ b14 DGDPt þ b15 T t þ et ð6Þ
11
With reference to the effect on Tier1, this includes retained earnings. Thus, banks characterized by low pre-managed capital could have more incentives to
reduce LLP by managing them downward. Concerning Tier 2, when loan loss reserves are lower than 1.25% of risk-weighted assets, an increase in LLP increases
Tier2 and, consequently, the total regulatory capital ratio (BCBS, 2006). Thus, the expected sign of the CAP variable depends on the relative amounts of Tier I and
Tier II capital, which determine the prevailing effect.
8
The coefficient of interest in model (6) is the coefficient of the interaction between EBTP i,t, SUPERVt, and ENFORCEt, which
expresses the effect of accounting enforcement on banks’ income smoothing in strict supervisory regimes. This coefficient is
expected to be negative and significant, as we predict that accounting enforcement reduces banks’ income smoothing under
strict prudential supervisors.
Finally, we test H3.a by running model (7) on two distinct subsamples: (a) banks in countries characterized by stricter
prudential supervision (strict supervisory regimes), and (b) banks in countries characterized by weaker prudential supervision
(weak supervisory regimes). To this end, we consider prudential supervision in a country as ‘strict’ when the power of the pru-
dential supervisor in the country is above the sample median and ‘weak’ otherwise:
LLPi;t = b0 + b1 EBTP i;t + b2 HIGHCORRECTIONS + b3 ENFORCEt + b4 EBTP i;t * HIGHCORRECTIONS
þ b5 EBTPi;t ENFORCEt þ b6 HIGHC ORRECTIONS ENFORCEt þ b7 EBTP i;t ENFORCEt HIGHC ORRECTIONS
þ b8 NPLOANSi;t1
X
þ b9 DLOANSi;t þ b10 LLAi;t1 þ b11 CHO FF i;t1 þ b12 SIZEi;t þ b13 REGC AP i;t þ b14 DGDPt þ b15 Tt þ et ð7Þ
In model (7), we examine the coefficients of the two terms. First, we focus on b5, which is the coefficient of the double
interaction between EBTP i,t and ENFORCEt and expresses the effect of accounting enforcement on income smoothing in coun-
tries characterized by a low level of supervisor corrections (HIGH_CORRECTIONS equals 0). We compare this coefficient with
b7, which is the coefficient of the triple interaction between EBTP i,t, ENFORCEt, and HIGH_CORRECTIONS and expresses the
effect of accounting enforcement on banks’ income smoothing in contexts characterized by a high level of supervisor correc-
tions (HIGH_CORRECTIONS equals 1).
We hypothesize that the effectiveness of supervision affects the impact of accounting enforcement on banks’ income
smoothing. Specifically, we expect that accounting enforcement reduces income smoothing in (i) strict supervisory regimes
that diffuse ex ante a transparency culture and, therefore, do not make high ex-post corrections to banks’ accounting figures,
and (ii) weak supervisory regimes that are not effective in diffusing ex ante a transparency culture but make many ex-post
corrections to banks’ accounting figures. We also expect that b5 (indicating the effect of accounting enforcement on smooth-
ing in the low-corrections case) is negative and statistically significant in banks under strict supervisory regimes and that b7
(indicating the effect of accounting enforcement on smoothing in the high-corrections case) is negative and statistically sig-
nificant in banks under weak supervisory regimes.12
All the models include dummy variables controlling for time effects that are bank invariant, and standard errors are clus-
tered by bank. The accounting variables included in the regression models are normalized by total assets at the beginning of
the year to mitigate potential estimation problems with heteroscedasticity. We also clear outliers and potential data errors
by excluding the values of each accounting variable collected outside the 1st and 99th percentiles.
4. Empirical results
The descriptive statistics for the bank-level variables are reported in Table 2. The mean (median) of LLP is 0.83% (0.38%),
and the mean (median) of the change in total loans is 4.11% (1,93%), indicating that, on average, total loans increase during
the timeframe of observation, and loan loss allowance is 2,52% (1,67%). The mean (median) of non-performing loans is
29.38% (0.5%), and that of loans charge-offs is 0.43% (0.34%).
The Pearson’s correlation coefficients between the dependent and independent accounting variables indicate a positive
correlation (p < 0.01) between LLPi,t and unmanaged earnings, suggesting that higher unmanaged earnings are associated
with higher provisions for loan losses (see Table 3, Panel A). Correlation analysis shows that LLPi,t are positively associated
with the variation of loans to the allowance for loan losses and loan charge-offs (p < 0.01), suggesting that the risk of loan
portfolios may be associated with the magnitude of LLPi,t. Further, the negative correlation (p < 0.01) between LLP and DGDPt
suggests the pro-cyclical effect of LLPi,t.
The correlations between the variables expressing the institutional features under investigation (strictness of prudential
supervision, intensity of market monitoring, and degree of accounting enforcement) are provided in Panel B. The intensity of
prudential supervision13 and MARKETt are negatively correlated (p < 0.01), suggesting that the power of supervisory authority
and market monitoring are substitutes rather than complements. Instead, the intensity of prudential supervision exhibits a neg-
ative correlation with ENFORCEt (p < 0.05), indicating that the strictness of prudential supervisors in a country does not neces-
sarily imply a high degree of accounting enforcement. Panel B also shows the correlation between the abovementioned features
and the magnitude of regulatory corrections to banks’ regulatory capital (TIER1), which is positively correlated with the power
of prudential supervisors and negatively correlated with the extent to which regulation enables investors to exert external gov-
ernance on banks and to the intensity of accounting enforcement.
12
Before comparing the coefficients, we perform the Hausman test on the coefficients of models run separately over the two subsamples and expect them to
be statistically significant.
13
In the correlation analysis, we report the continuous variable that represents the Official Supervisory Power Index (Barth et al., 2008, 2013).
9
Table 2
Descriptive statistics of bank-level variables.
Variable Mean Standard Deviation Min Q1 Median Q3 Max

LLPi,t 0.0083 0.0121 0.0000 0.0013 0.0038 0.0099 0.0757
EBTP i,t 0.1487 0.7768 1.1212 0.0023 0.0112 0.0445 5.5578
NPLOANS i,t-1 0.2938 1.1323 0.0000 0.0005 0.0050 0.0482 7.8516
DLOANS i,t 0.0411 0.1147 0.2362 0.0163 0.0193 0.0668 0.6703
LLA i,t-1 0.0252 0.0293 0.0000 0.0057 0.0167 0.0317 0.1869
CH_OFF i,t-1 0.4349 3.0276 0.0000 0.0003 0.0034 0.0254 26.2090
SIZE i,t 16.0708 2.2900 8.6940 14.5773 15.8938 17.4838 21.5360
REG_CAP i,t 0.5763 0.8840 0.0800 0.1144 0.1370 0.1719 0.7520
Note: All the variables are defined in Appendix 3.
Table 3
Pearson’s correlations for both accounting and macroeconomic variables and institutional features.
Panel A: Correlations between accounting and macroeconomic variables

Variables LLPi,t EBTP i,t NPLOANS i,t-1 DLOANS i,t LLA i,t-1 CH_OFF i,t-1 SIZE i,t REG_CAP i,t DGDPt
LLPi,t 1.0000
EBTP i,t 0.1833*** 1.0000
NPLOANS i,t-1 0.0552 0.3157*** 1.0000
DLOANS i,t 0.1028*** 0.0672* 0.0903** 1.0000
LLA i,t-1 0.5255*** 0.1071*** 0.0531 0.1186*** 1.0000
CH_OFF i,t-1 0.1044*** 0.5850*** 0.5893*** 0.081** 0.0194 1.0000
SIZE i,t 0.2503** 0.3622*** 0.4395*** 0.1563*** 0.2598*** 0.3755*** 1.0000
REG_CAP i,t 0.0273 0.016 0.0497 0.0316 0.0453 0.0182 0.0742** 1.0000
DGDPt 0.1487*** 0.0352 0.0158 0.2359*** 0.0637* 0.0347 0.0311 0.0055 1.0000
Panel B: Correlations between institutional features
Variables SUPERVt MARKETt ENFORCEt CORRECTIONS
SUPERVt 1.0000
MARKETt 0.2851*** 1.0000
ENFORCEt 0.4038** 0.5445*** 1.0000
CORRECTIONS 0.3841*** 0.3255*** 0.71091*** 1.0000
Note: All the variables are defined in Appendix 3.
The estimation results of model (1) confirm the positive association between LLPi,t and unmanaged earnings, as the coef-
ficient of EBTP i,t is positive and statistically significant (p < 0.01). This indicates that the sample banks smooth earnings
through LLPi,t, which increases in the case of high pre-managed earnings and decreases when pre-managed earnings are low.
The results for the variables controlling for the non-discretionary component of provisioning only partially confirm the
preliminary correlation analysis. On the one hand, LLA i,t-1 presents a positive and statistically significant coefficient
(p < 0.01), indicating a direct association with provisions due to the increase in the riskiness of loan portfolios (Fonseca &
González, 2008; Greenawalt & Sinkey, 1988; Wahlen, 1994). On the other hand, the coefficients of DLOANS i,t, CH_OFFi,t-1
and NPLOANS i,t-1 are positive but not statistically significant. In contrast with our expectations, the coefficient of SIZE i,t is
negative and statistically significant.
In line with previous EU-based research (Curcio et al., 2017; García-Osma et al., 2019; Gebhardt & Novotny-Farkas, 2011),
capital management issues do not seem to play a primary role in explaining LLPi,t for sampled banks, as the coefficient of
REG_CAP i,t is not statistically significant.
The cyclical effect of LLPi,t is confirmed by the negative coefficient of DGDPt (p < 0.01), in line with prior studies (Pérez
et al., 2008; Fonseca & González, 2008; García-Osma et al., 2019). The negative association between LLPi,t and DGDPt is also
consistent with Laeven & Majnoni (2003) and Bikker and Metzemakers (2005).
In our main tests, we examine the role of the supervisory features on banks’ income smoothing to assess whether the
strictness of the supervisory authority influences income smoothing and whether other supervisory features influence the
effect of strictness.
We first study the effect of strictness (H1) by estimating model (2) and find that the coefficient of the interaction term
EBTP i,t * SUPERVt is positive and statistically significant (p < 0.01). This result validates our first hypothesis, indicating that
the power of the national supervisory authority increases banks’ propensity to smooth income. This evidence lends empirical
support to the idea that powerful prudential supervisors influence the accounting practices of supervised banks, inducing
them to increase income smoothing to produce an appearance of financial stability by avoiding unusually high or low levels
of earnings, and substantially matching the preferences of regulators on loan loss accounting (García-Osma et al., 2019; Lobo,
10
2017). In other words, strict supervisors’ strong aversion to risks can produce the undesirable side effect of inducing banks to
increase earnings management, with a negative impact on the transparency of financial information.
Among the accounting variables controlling for the non-discretionary portion of LLPi,t, LLA i,t-1 exhibits a positive and
significant association with LLPi,t (p < 0.01), and the coefficient of DGDPt is negative and statistically significant
(p < 0.01), in line with our expectations. In contrast with our prediction, the coefficient of SIZE i,t is negative and statis-
tically significant.
To understand the overall effect of market monitoring and accounting enforcement on banks’ income smoothing, we
first provide an estimation of models (3) and (5). Model (3) allows us to examine whether income smoothing is influenced
by the governance exerted by private investors. The results suggest that market monitoring does not affect European
banks’ income smoothing, as the coefficient of the interaction variable EBTP i,t * MARKETt is negative but not statistically
significant.
Then, we estimate model (5) to examine whether accounting enforcement intensity affects banks’ income smoothing
independently of supervisory strictness. The results do not indicate an effect of accounting enforcement because the coef-
ficient of the interaction term EBTP i,t * ENFORCEt is not statistically significant (see Table 4, last column).
Then, we test whether market monitoring reduces the influence of strictness on banks’ income smoothing (H2). The
coefficient of the interaction variable EBTP i,t * SUPERVt * MARKETt in model (4) is negative and statistically significant
(p < 0.01), indicating that the effect of external governance by private investors on banks’ income smoothing differs sig-
nificantly between strict and weak supervision (see Table 5). Market monitoring reduces reporting opacity and counter-
balances the effect of prudential supervision in strict regimes, which generates incentives to smooth income for
opportunistic purposes. This result lends empirical support to the diversion hypothesis that external governance decreases
managerial discretion over accounting numbers (Leuz et al., 2003) and increases the reliability of bank earnings by reduc-
ing banks’ smoothing.
Additionally, the term EBTP i,t * MARKETt exhibits a significantly positive coefficient, suggesting that banks perceive mar-
ket monitoring as a substitute for monitoring by prudential supervisors in countries characterized by weaker regulators. This
result is consistent with the correlation analysis, indicating that national supervision and market monitoring are substitutes
rather than complements.
Finally, we analyze the effect of accounting enforcement on banks’ income smoothing under strict supervisors (H3) by
estimating model (6) and report those results in the last column of Table 5. The coefficient of the interaction term EBTP i,t
* SUPERVt * ENFORCEt is negative and significant (p < 0.05), indicating that the intensity of accounting enforcement mitigates
banks’ income smoothing in countries characterized by strict prudential supervision. In countries characterized by lower
penalties, the incentives to manipulate earnings are weaker, and greater enforcement does not modify the low level of banks’
income smoothing. This is shown by the coefficient of the interaction term EBTP i,t * ENFORCEt, which is not statistically sig-
nificant. Overall, these results support the view that, under powerful supervisors, the intensity of national enforcement
weakens managers’ incentives to engage in earnings management because they are more likely to incur corrections by
accounting enforcers.
We also explore how supervisory effectiveness influences the effect of accounting enforcement on income smoothing by
running model (7) separately on the two subsamples. The last columns of Table 5 provide the results of the estimations for
(a) banks under strict supervisory regimes and (b) banks under weak supervisory regimes.
The coefficient of the double interaction between EBTP i,t and ENFORCEt is negative and statistically significant. This result
confirms our expectations as it indicates that accounting enforcement reduces smoothing in countries characterized by
effective regulator activity (reflected by low supervisory corrections). Further, this finding suggests that, in these contexts,
strict supervisors are able to diffuse ex ante a supervisory culture informed by transparency. By contrast, the coefficient of the
triple interaction between EBTP i,t, ENFORCEt, and HIGH_CORRECTIONS is positive and significant, suggesting that accounting
enforcement amplifies the effect of supervisory strictness on banks’ earnings management.
In weak supervisory regimes, the accounting enforcement does not influence income smoothing when supervisory effec-
tiveness is low, as shown by the coefficient of the interaction between EBTP i,t and ENFORCEt, which is not statistically sig-
nificant. By contrast, the negative coefficient of the interaction between EBTP i,t, ENFORCEt, and HIGH_CORRECTIONS confirms
our expectation that enforcement reduces smoothing in countries characterized by supervisory effectiveness obtained
through ex-post corrections to bank figures.14
5. Additional analyses
This section describes additional analyses that include the moderation effect of IFRS and listing (Section 5.1) and those on
the effect of the introduction of the 2014 Single Supervisory Mechanisms (SSM) and the global financial crisis (Section 5.2). It
also describes robustness checks dealing with omitted variable-related issues and provides results obtained by introducing
other control variables in the regression models (Section 5.3). Appendix 4 explains the variables employed in the analyses.
14
We perform a Hausman test on coefficients of the models run over the two subsamples; the result is statistically significant at the 1% level (p-value =
0.0000).
11
Table 4
The effect of supervisory strictness, market monitoring and accounting enforcement on bank income smoothing.
LLP i,t Predicted sign Model (1) Model (2) – (H1) Model (3) Model (5)
Prudential Market Monitoring Accounting
supervision Enforcement
EBTP i,t + 0.0017 *** 0.0002 0.0058 0.0023
(0.0006) (0.0004) (0.0051) (0.0025)
SUPERVt ? 0.0017
(0.0011)
EBTP i,t * SUPERVt + 0.0038 ***
(0.0008)
MARKETt ? 0.0001
(0.0004)
EBTP i,t * MARKETt – 0.0005
(0.0006)
ENFORCEt ? 0.0001 **
(0.0000)
EBTP i,t * ENFORCEt + 0.0001
(0.0001)
NPLOANS i,t-1 + 0.0003 0.0001 0.0002 0.0001
(0.0054) (0.0004) (0.0006) (0.0012)
DLOANS i,t + 0.0030 0.0013 0.0001 0.0003
(0.0054) (0.0056) (0.0035) (0.0042)
LLA i,t-1 + 0.1267 *** 0.1270 *** 0.1359 *** 0.1475 ***
(0.0318) (0.0299) (0.0363) (0.0460)
CH_OFF i,t-1 + 0.0001 0.0001 0.0002 0.0002
(0.0003) (0.0002) (0.0003) (0.0003)
SIZE i,t + 0.0008 *** 0.0008 *** 0.0002 *** 0.0003
(0.0003) (0.0003) (0.0002) (0.0002)
REG_CAP i,t +/- 0.0031 0.0015 0.0054 0.0054
(0.0047) (0.0047) (0.0047 (0.0047)
DGDPt – 0.0415 *** 0.0416 *** 0.0328 *** 0.0330 ***
(0.0135) (0.0135) (0.0128) (0.0115)
Intercept ? 0.0217 *** 0.0205 ** 0.0163 *** 0.0132 ***
(0.0062) (0.0571) (0.0054) (0.0051)
Year Controls Yes Yes Yes Yes
R2 within 0.1515 0.1604 0.1189 0.0895
betweeen 0.3806 0.4289 0.4152 0.4426
overall 0.3109 0.3514 0.3424 0.361
Wald-Chi2 95.38 157.23 128.97 100.84
Observations 811 811 758 673
Banks 217 217 203 182
Notes: All the variables are defined in Appendix 3. * Denotes significance at 10% levels, two-tailed, respectively. ** Denotes significance at 5% levels, two-
tailed, respectively. ***Denotes significance at 1% levels, two-tailed, respectively.
5.1. Effect of IFRS and listing
We consider the potential moderation effect of IFRS due to the incurred loss approach implemented by IAS 39 from 2005 to
2015 because our sample includes both banks reporting under IFRS (190 banks) and those that use national Generally
Accepted Accounting Principles (GAAP) (27 banks).15 The results (see Table 6) reveal that reporting under IFRS has no mod-
eration effect, as the coefficient of the interaction term EBTP i,t * SUPERVt *IFRSi,t, is not statistically significant.
In addition, we consider the effect of listing on banks’ income smoothing, based on the idea that publicly traded banks are
more likely to smooth income (Beatty & Harris, 1999; Beatty, Ke, & Petroni, 2002; Nichols, Wahlen, & Wieland, 2009) and to
signal a low-risk profile to investors (Kanagaretnam et al., 2004). However, other arguments support the opposite prediction
– that listed banks engage less in income smoothing. First, publicly traded banks have incentives to provide transparent
financial statements and reduce earnings management (Burgstahler, Hail, & Leuz, 2006) because outsiders could be reluctant
to invest in entities revealing low accounting quality (Bouvatier, Lepetit, & Strobel, 2014). Second, non-publicly traded banks
could employ income smoothing as an alternative to portfolio diversification to hide risky business strategies (Fonseca &
González, 2008).
15
Our sample encompasses both listed banks reporting under IFRS due to the IAS Regulation and unlisted banks that apply either IFRS or national GAAP
depending upon the national requirements. Although the mandatory application of IFRS for banks is widespread, including Belgium, Bulgaria, Croatia, Cyprus,
Estonia, Finland, Greece, Italy, Latvia, Lithuania, Malta, Poland, Portugal, Romania, Slovakia, and Sweden, various European jurisdictions do not mandate that
unlisted banks apply IFRS, including Austria, the Czech Republic, Denmark, France, Germany, Hungary, Ireland, Luxembourg, the Netherlands, Spain, and the
UK.
12
Table 5
The combined effect of supervisory strictness, market monitoring and accounting enforcement on bank income smoothing.
LLPi,t Predicted sign Model (4) – H2 Model (6) – H3 Model (7) – H3.a
Market Accounting Accounting Enforcement
Monitoring Enforcement
Strict Weak
supervisory supervisory
regimes regimes
EBTP i,t + 0.0038 * 0.0047 1.3248 * 0.0041
(-0.0089) (0.0030) (0.7720) (0.0033)
SUPERVt ? 0.0089 0.0059 *
(0.0101) (0.0036)
EBTP i,t * SUPERVt + 0.0386 *** 0.0134 **
(0.0138) (0.0062)
MARKETt ? 0.0002
(0.0005)
EBTP i,t * MARKETt – 0.0004 **
(0.0002)
SUPERVt * MARKETt ? 0.0013 **
(0.0130)
EBTP i,t* SUPERVt * MARKETt – 0.0046 ***
(0.0018)
ENFORCEt ? 0.0001 ** 0.0004 0.0001 *
(0.0001) (0.0002) (0.0001)
EBTP i,t * ENFORCEt +/- 0.0001 * 0.0306 * 0.0001
(0.0001) (0.0178) (0.0001)
SUPERVt * ENFORCEt ? 0.0002 **
(0.0001)
EBTP i,t* SUPERVt *ENFORCEt – 0.0003 **
(0.0001)
HIGH_CORRECTIONS ? 0.0166 0.0034
(0.0119) (0.0053)
EBTP i,t * HIGH_CORRECTIONS ? 1.3170 * 0.0982 **
(0.7714) (0.0416)
HIGH_CORRECTIONS * ENFORCEt ? 0.0004 0.0001
(0.0003) (0.0001)
EBTP i,t * ENFORCEt * HIGH_CORRECTIONS +/- 0.0305 * 0.0022 **
(0.0178) (0.0009)
NPLOANS i,t-1 + 0.0002 0.0001 0.0032 ** 0.0067 ***
(0.0005) (0.0012) (0.0013) (0.0023)
DLOANS i,t + 0.0017 0.0004 0.0083 0.0007
(0.0041) (0.0042) (0.0054) (0.0045)
LLA i,t-1 + 0.1395 *** 0.1523 *** 0.3237 *** 0.1230 ***
(0.0330) (0.0441) (0.0723) (0.0477)
CH_OFF i,t-1 + 0.0003 0.0000 0.0016 0.0000
(0.0002) (0.0003) (0.0015) (0.0003)
SIZE i,t + 0.0006 *** 0.0004 0.0005 * 0.0009 **
(0.0002) (0.0002) (0.0003) (0.0005)
REG_CAP i,t +/- 0.0049 0.0050 0.0004 0.0023
(0.0047) (0.0048) (0.0030) (0.0041)
DGDPt – 0.0324 *** 0.032 *** 0.1175 *** 0.0597 *
(0.0124) (0.0115) (0.0232) (0.0311)
Intercept ? 0.0341 ** 0.0147 *** 0.0081 *** 0.0284 ***
(-0.0152) (0.0053) (0.0115) (0.0109)
Year Controls Yes Yes Yes Yes
R2 within 0.1414 0.0952 0.3257 0.1870
betweeen 0.4568 0.4588 0.6758 0.4015
overall 0.3753 0.3677 0.6174 0.3942
Wald-Chi2 288.08 121.09 604.24 455.58
Observations 758 673 226 303
Banks 203 182 82 85
Notes: All the variables are defined in Appendix 3. * Denotes significance at 10% levels, two-tailed, respectively. ** Denotes significance at 5% levels, two-
tailed, respectively. ***Denotes significance at 1% levels, two-tailed, respectively.
Based on these considerations, we perform additional tests to ascertain whether the relationship between income
smoothing and the power of the national supervisor is influenced by listing. In our sample, we find that listing does not mod-
ify the effect of national supervisory power on banks’ income smoothing,16 as the coefficient of the interaction term EBTP i,t *
SUPERVt * LISTi,t is not statistically significant (see Table 6, second column).
16
This result is in line with evidence provided by Curcio et al. (2017).
13
Table 6
The effect of IFRS, listing, the SSM Framework Regulation, and the financial crisis.
LLPi,t IFRS LISTING SSM Framework FINANCIAL CRISIS

Regulation
2003–2008 2009–2015
EBTP i,t 0.0006 * 0.0002 0.0003 0.0003 0.0006
(0.0004) (0.0004) (0.0004) (0.0006) (0.0004)
SUPERVt 0.0002 0.0004 0.0015 0.0027 0.0025 *
(0.0024) (0.0010) (0.0011) (0.0021) (0.0012)
IFRSi,t 0.0018
(0.0021)
SSMt 0.0053 **
(0.0023)
LISTi,t 0.0013
(0.0016)
EBTP i,t * SUPERVt 0.0115 0.0038 *** 0.0037 *** 0.0106 *** 0.0040 ***
(0.0177) (0.0008) (0.0008) (0.0012) (0.0012)
EBTP i,t * IFRSi,t 0.001
(0.0007)
SUPERVt * IFRSi,t 0.0018
(0.0025)
EBTP i,t* SUPERVt * IFRSi,t 0.0072
(0.0177)
EBTP i,t * SSMt 0.0008
(0.0009)
SSMt * SUPERVt 0.0015
(0.0017)
EBTP i,t* SUPERVt * SSMt 0.0006
(0.0013)
EBTP i,t * LISTi,t 0.0048
(0.0043)
SUPERVt * LISTi,t 0.0043 **
(0.0021)
EBTP i,t * SUPERVt * LISTi,t 0.0023
(0.0108)
NPLOANS i,t-1 0.0001 0.0001 0.0001 0.0008 0.0002
(0.0004) (0.0051) (0.0004) (0.0010) (0.0004)
DLOANS i,t 0.0012 0.0005 0.0013 0.0043 0.0034
(0.0056) (0.0051) (0.0056) (0.0074) (0.0084)
LLA i,t-1 0.1246 *** 0.1287 *** 0.1250 *** 0.1691 ** 0.1128 ***
(0.0301) (0.0284) (0.0301) (0.0698) (0.0324)
CH_OFF i,t-1 0.0001 0.0001 0.0001 0.0002 0.0002
(0.0002) (0.0002) (0.0002) (0.0003) (0.0002)
SIZE i,t 0.0008 *** 0.0008 *** 0.0008 *** 0.0002 0.0009 ***
(0.0003) (0.0003) (0.0003) (0.0003) (0.0003)
REG_CAP i,t 0.0017 0.0021 0.0015 0.0005 0.0057
(0.0047) (0.0047) (0.0046) (0.0031) (0.0060)
DGDPt 0.0423 *** 0.0413 *** 0.0415 *** 0.0026 0.0544 ***
(0.0135) (0.0134) (0.0135) (0.0141) (0.0210)
Intercept 0.0207 *** 0.0210 *** 0.0208 *** 0.0043 0.0162 ***
(0.0058) (0.0057) (0.0057) (0.0065) (0.0057)
Year Controls Yes Yes Yes Yes Yes
R2 within 0.1625 0.1657 0.1630 0.1836 0.0658
between 0.4283 0.4345 0.4287 0.5263 0.4018
overall 0.3506 0.3699 0.3492 0.4457 0.3457
Wald-Chi2 179.15 162.33 156.5 112.92 74.38
Observations 811 811 811 203 608
Banks 217 217 217 96 202
Notes: All the variables are defined in Appendix 3 and Appendix 4.* Denotes significance at 10% levels, two-tailed, respectively. ** Denotes significance at 5%
levels, two-tailed, respectively. ***Denotes significance at 1% levels, two-tailed, respectively.
5.2. Introduction of SSM Framework regulation and global financial crisis
We perform additional analyses given the possibility that the 2014 SSM Framework Regulation could have influenced
managers’ accounting decisions by introducing stronger supra-national governance. Multivariate regression results reveal
no incremental effect on managers’ use of LLP for smoothing purposes in the first periods of the SSM Framework Regulation,
as the coefficient of the interaction term EBTP i,t * SSMt * SUPERVt is not statistically significant (see Table 6, third column).
We also consider that the global financial crisis could have changed banks’ perceptions of supervisory power (El Sood,
2012). The 2008 bubble burst emphasized the importance of financial stability (Begg, 2009) and the need for a provisioning
14
system inspired by prudential objectives, with international oversight bodies calling for more latitude for banks’ LLP esti-
mates (FSF, 2009). This emphasis on accounting discretion could have increased income smoothing after the financial crisis
and, thus, may drive our results.
Therefore, we estimate model (2) separately for the periods before and after the global financial crisis (2003–2008 and
2009–2015, respectively) to explore whether income smoothing is driven by the changes occurring during and after the
financial crisis. The coefficient of the interaction term EBTP i,t * SUPERVt, is positive and statistically significant for both
the 2003–2008 and 2009–2015 periods at the 1% level (b1 – b2, p-value = 0.0001; see Table 6, last two columns). We obtain
similar results by running a modified model including a triple interaction term EBTP i,t * SUPERVt * POST_CRISISt. In this case,
the coefficient of the triple interaction term is not statistically significant, indicating no significant difference between the
two periods in terms of supervision’s effect on income smoothing (in untabulated results).
5.3. Omitted variables
We address omitted variables-related issues by running regression models with additional variables (see Appendix 4)
that could affect our results and are not included in our main models.
We introduce controls for the following firm-level variables: bank status (i.e. whether a bank is commercial or not), loan
mix, tangibility (in untabulated results), the bank’s ownership structure, corporate governance, and external auditing. In unt-
abulated results, we also include factors to control for the effect of formal and informal institutions to consider the potential
influence of the country’s rule of law, control of corruption, and strength of investor protection.
Our results are robust to these additional checks. The coefficient of the double interaction EBTP i,t * SUPERVt is still positive
and statistically significant (see Table 7, second column), confirming that strict supervision increases banks’ income smooth-
ing. These tests also confirm that the monitoring exerted by private investors and accounting enforcement have a moderat-
ing effect, reducing income smoothing under strict supervisors. Indeed, the coefficients EBTP i,t* SUPERVt * MARKETt and EBTP i,
t* SUPERVt * ENFORCEt are negative and statistically significant (see third and fourth columns of Table 7, respectively).
6. Conclusions
This study examined the effect of prudential supervision on banks’ income smoothing, exploring the influential role of
private investors and accounting enforcement as moderating factors in strict supervisory regimes. Our findings indicate that
banks’ propensity to smooth earnings is greater in strict supervisory systems, where banks try to avoid attracting regulators’
attention to avoid corrections and penalties. Indeed, unusually high or low earnings typically attract such attention, so banks
might decide to manipulate accounting numbers to exhibit a lower level of risk using a provisioning strategy apparently in
line with supervisors’ preferences. This result is consistent with the evidence found in Gebhardt and Novotny-Farkas (2011)
and García-Osma et al. (2019).
Our results also suggest that market monitoring and national accounting enforcement constrain income smoothing under
strict prudential supervisors. Consistent with Fonseca and González (2008), market monitoring reduces smoothing in strict
regimes while acting as a substitute for prudential supervision in countries characterized by weaker prudential supervisors.
Our findings confirm that national accounting enforcement helps reduce income smoothing under strict supervisors (Dal
Maso et al., 2018), suggesting that accounting enforcement counterbalances the drawbacks of supervisory strictness. We find
that accounting enforcement is particularly prone to reduce banks’ income smoothing in contexts characterized by effective
national supervision and when EU regulators effectively complement weak national supervision by making ex-post correc-
tions to bank figures. This finding supports the idea that accounting enforcers intervene actively, particularly in countries
characterized by effective prudential supervision, but leave broader scope for prudential supervisors’ interventions in other
cases.
Our findings provide important policy implications by suggesting that regulators should consider the effects of the super-
visory system’s features jointly, rather than in isolation, when evaluating supervisory reforms (Novotny-Farkas, 2016). This
point is instructional given the ongoing discussion regarding single supervisory mechanisms and the role played by national
authorities, who are often lenient when dealing with banks’ opaque practices (Fiordelisi et al., 2017). Specifically, these find-
ings suggest that regulators could limit the negative effect of prudential supervision on the transparency of bank financial
reporting by (i) strengthening market discipline that enables investors to exert effective governance on banks, and (ii)
achieving better coordination with accounting enforcers.
Our findings also provide important implications for global systemically important banks (G-SIBs),17 which require closer
scrutiny from a systemic regulation perspective because their instability could jeopardize the entire banking system’s stability
(Drehmann & Tarashev, 2013). Indeed, there is evidence that systemically important banks react to prudential scrutiny by
17
The 2008 financial crisis revealed the key importance of G-SIBs as the banks that pose the greatest systemic risk to the financial system. However, the
Financial Stability Board (FSB), as well as the Basel Committee on Banking Supervision (BCBS) and national regulators, has formally identified them as such only
since 2011 (Brunnermeier, Crockett, Goodhart, Persaud, & Shin, 2009; Markose, 2012; Markose, Giansante, & Shaghaghi, 2012). Each year, the FSB updates their
list and provides information on the application of specific measures to contain systemic and moral hazard risks. Research in the banking field has so far
examined whether insufficient bank capital, excessive risk-taking, poor loan-loss provisioning policies, or perverse regulatory incentives contributed to the near
collapse of some G-SIBs during the crisis (Acharya & Yorulmazer, 2007; Acharya, 2009; Gorton, Metrick, Shleifer, & Tarullo, 2010).
15
Table 7
Robustness of the main results to the introduction of additional explanatory variables.
LLPi,t Model (2) - H1 Model (4) – H2 Model (6) – H3

Prudential Supervision Market Monitoring Accounting Enforcement
EBTP i,t 0.0004 0.0032 0.0041
(0.0004) (0.0023) (0.0031)
SUPERVt 0.0014 0.0091 0.0057
(0.0011) (0.0101) (0.0037)
EBTP i,t * SUPERVt 0.0035 *** 0.0384 *** 0.0123 **
(0.0008) (0.0138) (0.0062)
MARKETt 0.0002
(0.0005)
EBTP i,t * MARKETt 0.0004 *
(0.0002)
SUPERVt * MARKETt 0.0013
(0.0013)
EBTP i,t* SUPERVt * MARKETt 0.0046 **
(0.0018)
ENFORCEt 0.0001 **
(0.0001)
EBTP i,t * ENFORCEt 0.0001
(0.0001)
SUPERVt * ENFORCEt 0.0002 **
(0.0001)
EBTP i,t* SUPERVt *ENFORCEt 0.0002 *
(0.0001)
NPLOANS i,t-1 0.0002 0.0001 0.0000
(0.0004) (0.0005) (0.0011)
DLOANS i,t 0.0021 0.0009 0.0003
(0.0057) (0.0041) (0.0043)
LLA i,t-1 0.1228 *** 0.1330 *** 0.1467 ***
(0.0309) (0.0356) (0.0458)
CH_OFF i,t-1 0.0001 0.0000 0.0000
(0.0002) (0.0002) (0.0000)
SIZE i,t 0.0006 * 0.0004 0.0003
(0.0003) (0.0003) (0.0003)
REG_CAP i,t 0.0015 0.0047 0.0050
(0.0047) (0.0046) (0.0048)
DGDPt 0.0392 ** 0.0317 *** 0.0315 ***
(0.0120) (0.0119) (0.0115)
COMMERCIALi,t 0.0011 0.0000 0.0001
(0.0014) (0.0010) (0.0011)
LOAN _MIXi,t 0.0001 *** 0.0001 ** 0.0001
(0.0000) (0.0000) (0.0000)
AUD_BIG4 i,t 0.0000 0.0000 0.0024
(0.0020) (0.0020) (0.0022)
INST_INVESTORi 0.0016 0.0017 0.0024 *
(0.0016) (0.0016) (0.0014)
CEO_AGEi 0.0001 0.0000 0.0000
(0.0000) (0.0000) (0.0000)
RULE_LAWt 0.0089 ** 0.0065 0.0020
(0.0043) (0.0045) (0.0035)
CORRUPT_CONTROLt 0.0060 0.0041 0.0006
(0.0037) (0.0038) (0.0032)
Intercept 0.0281 *** 0.0206 *** 0.0198 ***
(0.0087) (0.0067) (0.0066)
Year Controls Yes Yes Yes
R2 within 0.1803 0.1534 0.0962
between 0.4174 0.449 0.4605
overall 0.3557 0.3808 0.3732
Wald-Chi2 275.09 491.88 172.3
Observations 811 758 673
Banks 217 203 182
Notes: All the variables are defined in Appendix 3 and Appendix 4. * Denotes significance at 10% levels, two-tailed, respectively. ** Denotes significance at 5%
levels, two-tailed, respectively. ***Denotes significance at 1% levels, two-tailed, respectively.
smoothing income to hide their risks at the expense of transparency (Peterson & Arun, 2018). Therefore, strengthening market
discipline and coordination with enforcers may be even more critical in the case of G-SIBs as a way to limit the paradoxical
effect of strict supervision on transparency in banks with a major role in the stability of the financial system.
16
More generally, our evidence on the use of LLP for earnings management purposes suggests that regulators must pay
close attention to banks’ disclosure on LLP. Improved and extensive disclosure on LLP – especially for G-SIBs – would help
increase provisions estimates’ reliability, thus, assisting bondholders and stockholders in assessing loan portfolio quality (e.g.
Peterson & Arun, 2018).
Overall, our study raises issues that are particularly relevant given the recent application of IFRS 9 in Europe, as the new
standard leaves room for further managerial discretion in estimating provisions (Giner & Mora, 2019; Hashim, Li, &
O’Hanlon, 2016, 2019). In the absence of other forms of effective monitoring, banks under strict supervisors may find it even
easier to exploit earnings management to mask risky businesses, thus, jeopardizing financial stability and ultimately under-
mining regulators’ goals.
Our results should be considered in light of the study’s limitations. First, our analyses employ indirect proxies to measure
regulatory factors, and we use three-way interactions to estimate the effect of institutional features on income smoothing,
thus, reducing the extent to which it is possible to disentangle the effect of a single feature. Additionally, we do not directly
study the extent to which mechanisms of internal governance and ownership could moderate external monitoring’s effects
on banks’ income smoothing. Further, similar to other studies in the field, our results suffer from inherent limitations con-
cerning the measurement of the institutional variables, which are measured at two (prudential supervision and market mon-
itoring) or three (accounting enforcement) points in time. This may affect the accuracy of the standard errors estimated in
the multivariate regression analysis.
Future research may well provide additional evidence to further explore the effect on the relationship between strict
supervision and banks’ income smoothing, and identify other influential institutional variables.
Acknowledgements
We are grateful to Robert Larson (Editor) and the two anonymous referees for their constructive support in developing
the paper. We sincerely thank Araceli Mora and seminar participants in the XII Workshop on Empirical Research in Financial
Accounting (held in Exeter, UK, June 2017) for their insightful comments. We also gratefully thank Cristina Florio, the par-
ticipants in the VIII Financial Reporting Workshop (held in Parma, June 2017), and the participants in the XIII Workshop on
European Financial Reporting (held in Firenze, Italy, August 2017) for their valuable suggestions. Finally, we gratefully
acknowledge helpful comments from Luc Paugam on an earlier draft of this paper.
Appendix 1. Sample distribution, average data of country-level variables and data on corrections to capital ratios
COUNTRY Bank-year Banks Average Official Average Private Average Average value of
observations Supervisory Power Monitoring Accounting supervisory corrections
Index Index Enforcement Index to TIER 1
Austria 50 12 11.00 7.0 23.33 0.0091
Belgium 17 5 11.00 7.5 36.00 0.0049
Bulgaria 53 13 11.00 7.5 – –
Cyprus 51 12 11.50 9.0 – 0.0220
Czech 27 7 10.00 7.0 15.33 –
Republic
Denmark 15 5 10.50 9.0 41.67 –
Estonia 2 2 12.50 – – 0.0094
Finland 17 6 7.00 7.5 27.33 0.0050
France 156 39 9.25 9.0 42.33 0.0019
Germany 80 27 9.50 8.0 34.67 0.0028
Greece 5 1 9.00 8.5 21.33 0.0292
Hungary 4 2 13.75 8.5 16.67 –
Ireland 7 2 9.00 10.5 31.00 0.0032
Italy 92 21 10.00 8.0 41.00 0.0070
Latvia 9 2 11.00 8.0 – 0.0096
Lithuania 11 2 12.75 8.5 – 0.0043
Luxembourg 12 4 11.50 7.5 – 0.0022
Netherlands 40 11 10.59 9.5 25.33 0.0044
Poland 6 3 10.00 8.5 18.67 –
Portugal 29 6 13.00 6.5 23.67 0.0092
Romania 8 3 11.83 6.5 11.67 –
Slovenia 19 3 14.00 7.5 18.33 –
(continued on next page)
17
Sample distribution, average data of country-level variables and data on corrections to capital ratios (continued)
COUNTRY Bank-year Banks Average Official Average Private Average Average value of
observations Supervisory Power Monitoring Accounting supervisory corrections
Index Index Enforcement Index to TIER 1
Spain 17 4 10.75 9.0 32.00 0.0014
Sweden 7 4 8.00 7.0 28.67 –
United 77 21 8.00 10.5 46.67 –
Kingdom
Total 811 217
Note: See Appendix 2 for Index definitions.
Appendix 2. Indexes employed to construct institutional variables used in the analyses
INDEX DESCRIPTION
Official Supervisory Power Index Provided by Barth et al. (2008; 2013). A proxy for the strictness of the national
competent authority in charge of prudential supervision. The index expresses
Index ranging from 0 to 14,5 the extent to which the national supervisory authorities have the power to
obtain information from banks and to undertake measures (corrective actions
[larger numbers indicate greater and penalties) in order to change the entities’ behaviors. It measures the
national supervisors’ power] degree to which the national supervisor has the authority to take specific
actions. Built by weighting the answers to specific survey questions, mainly
concerning the supervisors’ right:
(i) to order the bank’s directors or management to constitute provisions to
cover actual or potential losses,
(ii) to force a change within the banks’ internal structure;
(iii) to suspend the distribution of the dividends, bonuses, and management
fees, and to remove and replace managers and directors;
(iv) to supersede shareholders’ rights proclaiming the bank insolvent.
Private Monitoring Index Provided by Barth et al. (2008; 2013). Expresses extent to which regulation
enables private investors to monitor banks’ behaviors and to exert an effective
Index ranging from 0 to 12 governance on the banks. The index was constructed using several tools:
(i) the requirements of ratings from international-rating agencies,
[larger numbers indicate higher (ii) the pressure for accurate, comprehensive and consolidated disclosure
private monitoring] of information concerning banks’ activities and their risk-
management policies;
(iii) the legal liability of directors for incorrect information or information
which could mislead users whether banks must be audited by certified
international auditors;
(iv) the consideration of subordinated debt as part of capital.
AETOTAL Index Provided by Brown et al. (2014). Expresses the intensity of national
accounting enforcement and encompasses both the quality of the public
Index ranging from 0 to 56 company auditors’ working environment (AUDIT Index) and the degree of
accounting enforcement activity (ENFORCE Index) by independent enforce-
[larger numbers indicate higher ment bodies. The overall index includes nine items relating to the audit
accounting enforcement] function and six relating to the accounting enforcement body. Data for the
AUDIT index are extracted from International Federation of Accountants (IFAC)
surveys and the World Bank’s ROSC reports, one item from the Worldscope
database, and one from Wingate (1997). Data for the ENFORCE Index derive
from hand collection from annual reports issued by security market regulators
and confirmed against data from IFAC (2011), FEE (2001) and CESR (2007,
2009). The data for item 6 are from Jackson and Roe (2009), Courtis (2006) and
Horakova (2011).
18
Appendix 3. Definition of the variables included in the main models
Variable Definition Model

Dependent variable
LLPi,t Loan loss provisions reported by the bank i in year t scaled by lagged total (1), (2), (3), (4),
assets (5), (6)
Independent variables
EBTP i,t Earnings before taxes and provisions at year t scaled by lagged total assets (1), (2), (3), (4),
(5), (6)
SUPERVt Dummy variable equal to 1 if the country presents a level of the Official (2), (3), (4), (5),
Supervisory Power Index (Barth et al., 2008; 2013) above the median, and 0 (6)
otherwise.A continuous variable using the values of the Official Supervisory
Power Index (Barth et al., 2008; 2013):
from 2003 to 2010: Official Supervisory Power Index constructed through
Survey III
from 2011 to 2015: Official Supervisory Power Index constructed through
Survey IV
Calculated through a ponderation of answers to ten main questions
addressing different aspects qualifying this peculiar feature ranges from
0 to 14,5. Higher values assumed by the variable indicate greater power
of the national competent authority.
MARKETt Proxy for market monitoring using the values of the Private Monitoring Index (3), (4)
(Barth et al., 2008; 2013):
from 2003 to 2010: Private Monitoring Index constructed through Survey
III
from 2011 to 2015: Private Monitoring Index constructed through Survey
IV
Expresses the degree to which regulatory and supervisory policies stim-
ulate the private monitoring of banks. This index assumes values from 0
(lowest level of regulatory empowerment of monitoring of banks by pri-
vate investors) to 12 (highest level of regulatory empowerment of mon-
itoring of banks by private investors).
ENFORCEt Proxy for the intensity of accounting enforcement using the values of the (5), (6), (7)
AETOTAL Index (Brown et al., 2014):
2003 and 2004: AETOTAL Index provided for the year 2002
from 2005 to 2007: AETOTAL Index provided for the year 2005
from 2011 to 2015: AETOTAL Index provided for the year 2008
Measures the degree of accounting enforcement across different national
contexts. The index combines the degree of accounting enforcement
activity by national enforcement bodies with the quality of auditors’
working environment and ranges from 0 to 56.
HIGH_CORRECTIONS Dummy variable equal to 1 if, in the country, the magnitude of corrections (7)
made by the ECB to bank TIER1 capital is above the median, and 0 otherwise.
Based on the variable CORRECTIONS, which is the magnitude of corrections
made by the ECB to bank TIER1.
NPLOANS i,t-1 Non-performing loans reported by bank i at the beginning of year t, scaled (1), (2), (3), (4),
by lagged total assets (5), (6), (7)
DLOANS i,t Change in loans reported by bank i from year t-1 to year t scaled by lagged (1), (2), (3), (4),
total assets (5), (6), (7)
LLA i,t-1 Beginning balance of loan loss allowance reported by bank i scaled by lagged (1), (2), (3), (4),
total assets (5), (6), (7)
CH_OFF i,t-1 Net loan charge-offs reported by bank i at the beginning of year t, scaled by (1), (2), (3), (4),
lagged total assets (5), (6), (7)
SIZE i,t Natural logarithm of total asset reported by bank i in year t (1), (2), (3), (4),
(5), (6), (7)
(continued on next page)
19
Definition of the variables included in the main models (continued)
Variable Definition Model

REG_CAP i,t Total regulatory capital ratio (total regulatory capital scaled by risk- (1), (2), (3), (4),
weighted assets) of the bank i in year t (5), (6), (7)
DGDPt Growth of the gross domestic product (GDP) from year t1 to year t for the (1), (2), (3), (4),
country (5), (6), (7)
Appendix 4. Definition of the additional explanatory variables used in the robustness tests
Variable Definition Source

IFRSi,t Dummy variable equal to 1 if bank i reports under IFRS, and BankScope
0 otherwise
SSMt Dummy variable equal to 1 if the SSM Framework –
Regulation is in force in year t, and 0 otherwise
LIST i,t Dummy variable equal to 1 if bank i is listed, and 0 BankScope
otherwise
LOAN_MIXi,t Loans to banks reported by bank i scaled by total loans in BankScope
year t
COMMERCIALi,t Dummy variable equal to 1 if bank i is a commercial bank, Bankscope
and 0 otherwise
AUD_BIG4 i,t Dummy variable equal to 1 if bank i is audited by an auditor BankScope
from a Big-Four audit firm, and 0 otherwise
INST_INVESTORi Dummy variable equal to 1 if the stake held by institutional SNL – S&P Market Intelligence
investors in bank i is higher than 50%, and 0 otherwise
CEO_AGEi Age of the Chief Executive Officer of the bank i SNL – S&P Market Intelligence
RULE_LAWt Rule of law – Estimate. Country-level index expressing the WorldBank (Worldwide
extent to which agents have confidence in and abide by the Governance Indicators, by
rules of society in year t (specifically, quality of contract Kaufmann et al., 2014)
enforcement, property rights, police, and the courts, the
likelihood of crime and violence)
CORRUPT_CONTROLt Control of Corruption – Estimate. Country-level index WorldBank (Worldwide
expressing the extent to which public power is exercised Governance Indicators, by
for private gain in year t (in particular, different forms of Kaufmann et al., 2014)
corruption, and ‘‘capture” of the state by elites and private
interests).
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Income Smoothing Monitoring Mechanism

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Journal of International Accounting, Auditing and Taxation 43 (2021) 100385

Contents lists available at ScienceDirect

Journal of International Accounting,

Income smoothing in European banks: The contrasting effects of

2. Literature review and hypothesis development

2.1. Agency issues, information asymmetry, and income smoothing in banks

2.2. Effect of strict prudential supervision on bank income smoothing

2.3. Moderation effect of market monitoring

2.4. Moderating effect of accounting enforcement

3.2. Econometric models

3.2.1. Modeling banks’ income smoothing

Country Barth et al. (2008, 2013) Brown et al. (2014)

3.2.2. Testing effect of institutional features on banks’ income smoothing

Variable Mean Standard Deviation Min Q1 Median Q3 Max

Note: All the variables are defined in Appendix 3.

Panel A: Correlations between accounting and macroeconomic variables

Note: All the variables are defined in Appendix 3.

5.1. Effect of IFRS and listing

LLPi,t IFRS LISTING SSM Framework FINANCIAL CRISIS

5.2. Introduction of SSM Framework regulation and global financial crisis

5.3. Omitted variables

LLPi,t Model (2) - H1 Model (4) – H2 Model (6) – H3

(continued on next page)

Appendix 2. Indexes employed to construct institutional variables used in the analyses

Appendix 3. Definition of the variables included in the main models

Variable Definition Model

(continued on next page)

Definition of the variables included in the main models (continued)

Variable Definition Model

Variable Definition Source

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