Banks’ Income Smoothing via Loan Loss Provisions : The Influence of the National Supervisory System in the European Context

This paper explores the impact of institutional factors on earnings management by investigating whether and to what extent the features of the national supervisory system affect banks' income smoothing through loan loss provisions (LLP). To address this issue, we consider the supervisory authority characteristics (strictness and effectiveness) and the role of market and external auditors based on the idea that they provide banks with different incentives to smooth earnings. Focusing on the European context, we find that income smoothing is higher in strict regimes, in line with the penalty hypothesis. However, under strict supervisors, evidence shows that private monitoring and the supervisory effectiveness in enforcing regulation reduce smoothing. By contrast, an active auditors' involvement in supervisory activities increases income smoothing, suggesting a considerable relevance of auditors' reputational concerns. Our findings show that supervisory power can produce an undesirable impact on accounting transparency when not combined with other monitoring levers