INSTITUTIONAL OWNERSHIP AND EARNING MANAGEMENT BY BANK HOLDING COMPANIES

• DOI: http://doi.org/10.1111/jfir.12120
• Author: Elyas Elyasiani,Yuan Wen,Rongrong Zhang
• Published date: 01 June 2017
• Date: 01 June 2017

INSTITUTIONAL OWNERSHIP AND EARNING MANAGEMENT BY

BANK HOLDING COMPANIES

Elyas Elyasiani

Temple University

Yuan Wen

SUNY New Paltz

Rongrong Zhang

Georgia Southern University

Abstract

We explore the role of institutio nal investors as a source of market di scipline in

mitigating earning managem ent (EMGT) by bank holding com panies (BHCs). We

propose that ownership by monitoring institutions ( institutional investor s with large

and long-term stakes and ind ependence from managers) is associated w ith less EMGT

because they have greater incenti ves/skills for monitoring their i nvestees than other

shareholders. We find that EMG T by BHCs is negatively associat ed with ownership

by monitoring institution s for larger and riskier banks and for th e post-SunTrust

decision period. Nonmonitor ing institutional ownership is un associated or in some

cases weakly or even positively assoc iated with EMGT. Our findings suggest th at

regulators should facilit ate ownership by monitorin g institutions as a complemen t to

regulation.

JEL Classification: G21, G23, G38

I. Introduction

We explore the role of institutional investors in mitigating earnings management

(EMGT) in publicly traded U.S. bank holding companies (BHCs). EMGT by banks is of

interest to academic researchers and regulators because it deepens the information

asymmetry between corporate insiders and outside stakeholders (creditors, shareholders,

and regulators) and thereby potentially elevates social costs. Institutional owners, in

particular, those with large equity stakes and longer term investment horizons, have

strong incentives to serve as monitors to limit managerial opportunism and risky

accounting practices, especially when these practices are clearly detrimental to the

interest of the firm. This is because these owners benefit from monitoring to a larger

extent, compared to other shareholders, and have the voting power and skills to achieve

the desired results.

Extant studies find that corporate managers manipulate financial reporting for

various reasons, for example, to meet or beat analyst forecasts (Habib and Hossain 2008)

or to increase the value of their equity holdings (Cheng and Warfield 2005; Bergstresser

The Journal of Financial Research Vol. XL, No. 2 Pages 147–178 Summer 2017

147

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and Philippon 2006). In regulated industries such as banking, managers may also engage

in EMGT to: avoid lawsuits based on “prudent-man laws,”

1

escape disciplinary actions

from bank examiners, pass regulatory tests for capital adequacy, reduce the chances of

their applications for mergers and acquisitions being denied, and boost their

performance-based compensations. Moreover, banks may practice EMGT to avoid

the loss of major clients for guarantee services (standby letters of credit and loan

commitments) and counterparty positions in derivatives, and to eschew negative

announcements to the market. In these cases, EMGT takes the form of increasing the

earnings. In some other cases, however, EMGT could decrease earnings, for example, to

raise cookie jar reserves or to reduce the stock price before insiders’share purchases

(Badertscher et al. 2009).

EMGT patterns of banks may be dissimilar from those of nonbank firms because

they are substantially more leveraged, more heavily regulated, and more opaque

(Diamond 1984; Morgan 2002; Flannery, Kwan, and Nimalendran 2004). Moreover,

assets and liabilities of banks (loans and deposits) are unique and dissimilar from those of

nonbank firms. The effect of regulation on bank EMGT is not clear-cut. On the one hand,

regulatory oversight, fear of prosecution, and concerns about possible loss of business

due to regulatory violation deter banks from engaging in EMGT. On the other hand, bank

managers could be motivated to engage in EMGT to avoid regulatory intervention and

disciplinary action, as well as attract demand for their guarantee products. For example,

regulatory capital requirement may encourage banks to understate their loan loss

provisions as a percentage of total loans (LLP) or to manage their realized securities

gains/losses as a ratio of total assets (RSG) in order to artificially improve their capital

ratios (Moyer 1990; Beatty, Chamberlain, and Magliolo 1995). Cheng, Warfield, and Ye

(2011) show that the motivation for EMGT by banks depends on the likelihood of

regulatory intervention; banks with low capital (likely to be subject to regulatory

intervention) show strong incentives for EMGT whereas those with adequate capital do

not. Regulatory intervention in response to EMGT by banks could take the form of

downgrading the CAMELS rating of the bank and/or regulatory actions by the U.S.

Securities and Exchange Commission (SEC).

2

The tools employed by banks for EMGT are also dissimilar from those used by

nonbank firms because bank assets and liabilities (loans and deposits) are unique in

nature. Bank managers can artificially inflate earnings by understating loan loss

provisions and/or manipulating realized securities gains/losses (Beatty, Chamberlain,

and Magliolo 2002). We use the absolute value of the discretionary component of loan

loss provisions as a ratio of total loans (ABS_DLLP) and the absolute value of the

discretionary component of realized securities gains/losses as a ratio of total assets

1

Prudent-man laws are designed to protect small investors. They allow investors to seek damages from

fiduciaries that do not invest in their best interests. These laws incentivize the fiduciaries to invest in safer assets

(because these assets can be easily defended in court) and encourage them to engage in EMGT to produce a rosier

picture.

2

See the next section and footnotes 5 and 6 for an example and more details on regulatory action. We thank an

anonymous referee for raising this point, and Julapa Jagtiani of the Federal Reserve Bank of Philadelphia for

discussion.

148 The Journal of Financial Research

(ABS_DRSG) as our measures of EMGT. These components qualify as measures of

EMGT because they are determined not by innate factors but rather by the discretion of

the managers.

The existing literature documents that institutional investors play a positive

role in corporate governance via influencing CEO compensation schemes (Khan,

Dharwadkar, and Brandes 2005), demanding conservative accounting practices

(Ramalingegowda and Yu, 2011), and/or affecting other governance-related issues

such as board independence and removal of poison pills (Gillan and Starks 2000).

Institutional owners of financial firms are also known to curtail firm risk, advance

firm performance, and reduce their cost of debt (Cheng, Elyasiani, and Jia 2011;

Elyasiani, Jia, and Mao 2010; Elyasiani and Jia 2008).

3

However, no study has

addressed the effect of institutional owners’monitoring on EMGT by BHCs. We

seek to fill this void.

We focus on the “monitoring institutions”—institutional investors with

strong incentives, skills, and voting power to monitor. This group is defined as

including investors that are (1) “dedicated”as classified by Bushee (1998, 2001) and

(2) “independent”from the management as classified by Brickley, Lease, and Smith

(1988). Because of differences in the client base, liquidity needs, and demographics,

institutional investors differ in their ownership concentration and investment

horizons (Gasper, Massa, and Matos 2005). In particular, dedicated institutions tend

to have large and long-term holdings in only a few firms. These features give rise to

“relationship investing,”rendering short-term trading increasingly unattractive and

monitoring increasingly desirable (Hirschman 1970). Independent institutional

investors are those that are less likely to have business connections with their

investee firms and therefore do not have concerns about losing business with the

latter.

We propose that monitoring institutions are associated with less EMGT for

three reasons. First, institutional investors with long investment horizons do not focus

on short-term performance , and hence, managers of the ir investee firms have less

incentive to engage in EMGT to sho w better performance (Bushee 20 01; Koh 2007).

Attig et al. (2013) find that the cost of equity is lower in the presence of institutional

investors with long invest ment horizons because of impr oved monitoring and

information quality. Along the same lines, Elyasiani, Jia, and Mao (2010) find a

negative relation between the cost of debt and institutional ownership stability.

Similarly, Stein (1988, 1989) suggests that the presence of shareholders with relatively

long investment horizons can mitigate managers’incentives for myopic investment

decisions. In the same contex t, Burns, Kedia, and Lipson (20 10) find that ownership

by short-horizon institutional investors is associated with higher discretionary

accruals, suggesting that the presence of these investors inc reases EMGT. It can

therefore be expected that improv ed monitoring and enhanced inform ation quality due

to longer horizon institut ional ownership also limit EM GT by BHCs. Second, the large

3

Institutional investors include investment companies, independent investment advisors, public pension

funds, bank trusts, insurers, and so on.

Institutional Ownership and Earning Management 149