Can regulatory enforced disclosure policy enhance earnings quality of banks?

Indian banking system was exposed to a regulatory overhaul during 2015–2016 through many policy reforms. These reforms came in tandem with the asset quality review (AQR) instituted by the banking regulator. One of such reforms was an enforcement of mandatory disclosures which aimed at improving earnings quality. The banking regulator framed these disclosures in terms of divergence in asset qualities between the regulator and the banks. The goal was to limit the opportunistic behavior of banks, reduce their ability to suppress unfavorable information, and improve certainty about the banking sector – which is opaque in general. Therefore, our study examines the efficacy of this policy – whether the mandatory disclosure policy reduced information asymmetry making the banks better disciplined, thereby alleviating to an extent the moral hazard problem. Using fixed effects panel regression and generalised methods of moments (GMM), we find divergence disclosure to have a positive effect on earnings quality. We witnessed banks to reduce the discretionary portion of the loan loss provisioning after the enforcement of divergence disclosure. Thus, the policy-making process to improve transparency and surfacing ‘good’ versus the ‘bad’ banks was effective and derived the intended results. Furthermore, our study recommends institutionalizing a metric driven policy approach to steer regulatory outcomes. For example, we propose the policy convergence initiated in 2022, to adopt the expected credit loss standard for credit impairment from the current incurred loss to be looked at with the lens of earnings quality. A mandatory disclosure with divergence in provision between the two credit loss models could be a possible solution to ensure realization of the intended policy outcome.