Effects of Declining Bank Health on Borrowers’ Earnings Management Activity : Evidence from the European Sovereign Debt Crisis

This study investigates whether the deterioration of a bank's financial health affects its borrowers' earnings management activity. To examine this issue, we consider the setting of the European sovereign debt crisis as a shock to the health of certain European banks that were severely affected and significantly decreased their lending volume during the crisis. This setting represents an exogenous shock to German non-financial firms because these firms were not directly affected by the crisis. We use a difference-in-differences research design, and firms with lending relationships with non-exposed banks are used as controls. Using various discretionary accrual measures and a timely loss recognition concept to evaluate earnings management, we find mixed evidence. Our investigation of discretionary accruals reveals that during the European sovereign debt crisis, exposed banks' borrowers do not engage in more or less earnings management than other borrowers. However, we find significant evidence that exposed banks' borrowers are more likely to report losses in a timelier manner. Overall, our results provide new insights into the indirect consequences of the sovereign debt crisis for firms' earnings management