Income smoothing in European banks: The contrasting effects of monitoring mechanisms

This study provides evidence of the combined effect of various monitoring mechanisms on 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 income smoothing, consistent with the idea that strict supervision increases banks’ incentives to signal business stability by managing earnings. However, the effect of prudential supervision is conditional on the intensity of market discipline and accounting enforcement, which reduce income smoothing only in strict supervisory regimes. The analysis also takes into account the effectiveness of prudential supervision, measured by considering the powers of national regulators and the results of financial health checks performed by European Union regulators. The results show that the effectiveness of prudential supervision 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.