National Supervision and Income Smoothing in Banks’ Annual Reports

This book tackles the debated relationship between the characteristics of national supervisory systems and manipulative practices in banks’ annual reports, with a specific focus on income smoothing. Since the 2008 financial crisis, governmental bodies and regulators have stressed the crucial role of supervision for bank transparency purposes, but the effects of supervision on accounting manipulation are still discussed.

The volume investigates whether the characteristics of national supervision affect bank propensity to smooth income. It also considers the potential role of bank business model, as recent research suggests its influence on banks’ accounting manipulations.

The empirical analysis employs a single rich dataset including data from financial statements of European banks from 2003 to 2015, country-level variables for the supervisory style, and data from the Asset Quality Review conducted by the European Central Bank. Overall, the evidence provided enables comparison between the effects of different supervisory features and gaining a broad understanding of the phenomenon.

Following the introduction of Regulation (EC) No 1606/2002, listed banks in Europe must prepare their annual reports under International Financial Reporting Standards (IFRS) (Quagli, 2019). In addition, in many European countries also unlisted banks apply IFRS instead of national GAAP, depending upon national requirements (Pacter, 2017). For instance, in Italy banks are required to prepare their financial statements under IFRS and this applies whether or not the company’s securities are traded on a regulated exchange (Di Pietra, 2008). Anyway, the mandatory application of IFRS for banks is quite diffused; this happens also in Belgium, Bulgaria, Croatia, Cyprus, Estonia, Finland, Greece, Latvia, Lithuania, Malta, Poland, Portugal, Romania, Slovakia and Sweden.

Given banks’ crucial role of financial intermediation between depositors, one of the main goals of the revision of the supervisory system that followed the 2008 financial crisis was increasing bank transparency. From this angle, ‘high-quality’ supervision should not only increase the overall sustainability of banks’ activities and bank ability to manage risks, but also contribute to improve the quality of bank accounting data (BCBS, 2015).

The features of the supervisory system are key to explain bank accounting choices; however, research suggests that the supervisory facets produce distinct incentives for bank managers to engage in income smoothing. The previous chapter has outlined empirical evidence provided by studies on the topic, highlighting that—at least in the European context—the strictness of national supervisors seems to increase income smoothing, as this strategy is substantially in line with supervisors’ prudential approach to provisioning (Gebhardt & Novotny-Farkas, 2011; García-Osma et al., 2019; Di Fabio et al., 2020). Its effect can be constrained by high independence of supervisors from the banking industry (García-Osma et al., 2019) and by private investors’ monitoring (Fonseca & González, 2008). Other two supervisory features, namely the involvement of external auditors and supervisory effectiveness, have been less investigated; however, recent research suggests that the supervisor’s reliance on the audit function is positively related to smoothing in market-oriented banks (Di Fabio, 2019) and that effectiveness seems to influence how other monitoring mechanisms reduce smoothing (Di Fabio et al., 2020).

Recent research supports the idea that banks characterised by business models drawing more on traditional retail funding, namely customer deposits, and income diversification is likely to engage more in income smoothing than other business models (Di Fabio, Journal of Applied Accounting Research 20:311–330, 2019). Indeed, being income smoothing an accounting behaviour consistent with entities’ aim to show lower riskiness, findings of this research are overall consistent with literature suggesting that traditional funding and income diversification strategies implemented by retail banks are an integral part of a strategy characterised by risk aversion (Köhler, Journal of Financial Stability 16:195–212, 2015). Additionally, evidence provided in the fourth chapter corroborates prior literature supporting the view that supervisory strictness is associated with income smoothing behaviours (Gebhardt & Novotny-Farkas, Journal of Business Finance and Accounting, 38:289–333, 2011; García-Osma et al., Journal of Banking and Finance, 102:156–176, 2019; Di Fabio et al., Journal of International Accounting, Auditing and Taxation, 43: 100385, 2020). This chapter aims to understand whether supervisory features have specifically an impact on accounting behaviour of banks characterised by certain business models.

The empirical analyses presented in this book provide evidence of how distinct features of the multifaceted supervisory system influence banks’ propensity to smooth income. The analyses employ a common dataset; thus, the findings offer a broad overview of the effects of different supervisory features also enabling comparison. In addition, the book provides evidence on the effect of external auditors’ involvement in supervisory activities on bank accounting behaviours. Besides, the findings offer further empirical support to the view that tightening restrictions to banking activities exerts a constraining effect on smoothing behaviours of retail-funded banks. The findings suggest that regulators and supervisors should adequately assess the actual effects of their decisions on bank accounting behaviours. In the European context, it is even more important in the light of the recent application of IFRS 9, which allows prompter recognition of loan losses but also implies more discretion in estimating provisions. In addition, evidence indicates that prudential and accounting regulators should devote attention to requirements on provisions-related disclosure. From a regulatory perspective, evidence on the relevance of the business model to explain accounting behaviour remarks the key part played by the business model analysis in understanding the entities’ reporting incentives and the reasons that explain manipulative practices in annual reports.