Bank Earnings Management and Tail Risk during the Financial Crisis

 
LEE J. COHEN
                             MARCIA MILLON CORNETT
                             ALAN J. MARCUS
                             HASSAN TEHRANIAN

Bank Earnings Management and Tail Risk during
the Financial Crisis

                             We show that a pattern of earnings management in bank financial statements
                             has little bearing on downside risk during quiet periods, but seems to have a
                             big impact during a financial crisis. Banks demonstrating more aggressive
                             earnings management prior to 2007 exhibit substantially higher stock mar-
                             ket risk once the financial crisis begins as measured by the incidence of large
                             weekly stock price “crashes” as well as by the pattern of full-year returns.
                             Stock price crashes also predict future deterioration in operating perfor-
                             mance. Bank regulators may therefore interpret them as early warning signs
                             of impending problems.

                                                                JEL codes: G01, G11, G21, G28, M40
                                       Keywords: financial institutions, earnings management, crashes,
                                                                                       financial crisis.

                         BANK INVESTORS HAVE LONG been concerned with tail risk,
that is, extreme declines in a bank’s stock price. The financial crisis of 2007–09
only heightened this concern. While regulators are more concerned with operating
performance than stock prices per se, they too must be concerned with dramatic
stock price declines to the extent that such declines signal deterioration in future
performance (as we show below). Moreover, contingent capital regulation with market
value triggers also can make stock prices relevant to regulators.
   The authors are grateful to Jim Booth, Ozgur Demirtas, Atul Gupta, Jim Musumeci, Jun Qian, Sugata
Roychowdhury, Ronnie Sadka, Phil Strahan, and seminar participants at Boston College for their helpful
suggestions.
   LEE J. COHEN is Assistant Professor of Finance, Finance Department, University of Georgia (E-mail:
leecohen@uga.edu). MARCIA MILLON CORNETT is Professor of Finance, Finance Department, Bentley Uni-
versity (E-mail: mcornett@bentley.edu). ALAN J. MARCUS is Mario J. Gabelli Professor of Finance, Finance
Department, Boston College (E-mail: alan.marcus@bc.edu). HASSAN TEHRANIAN is the Griffith Family Mil-
lennium Chair in Finance, Finance Department, Boston College (E-mail: hassan.tehranian@bc.edu).
Received January 25, 2012; and accepted in revised form November 6, 2012.

Journal of Money, Credit and Banking, Vol. 46, No. 1 (February 2014)

C 2014 The Ohio State University
172   :   MONEY, CREDIT AND BANKING

   While tail risk is determined in large part by bank financial policies such as the
composition of on- and off-balance-sheet asset and liability portfolios, the ability to
assess that risk also depends on bank reporting and accounting policies. For example,
banks have discretion in setting the level of several key income statement accounts
such as provisions for loan losses, and they can use that discretion to modulate the
transparency, or opacity, of their financial reports. While earnings management may
not directly cause tail events, it nevertheless may affect the best estimate of tail ex-
posure conditional on observable bank attributes. For example, Jin and Myers (2006)
and several others have shown for industrial firms that reductions in transparency are
associated with increased tail risk. This paper asks whether the association between
earnings management, which may be used to obscure true performance, and tail risk
also characterizes banks, and, in particular, whether earnings management predicted
bank performance during the financial crisis.
   Earnings management can increase the risk of extreme stock market returns if it
limits the availability of information about the firm. In Jin and Myers (2006), firm
managers use their discretion to impede the flow of public information about firm
performance. Managers normally have an incentive to postpone the release of bad
news, but in some circumstances either that incentive or the ability to hide informa-
tion collapses, leading to a sudden release of accumulated negative information and
a firm-specific stock price crash. In a more general setting, even if earnings manage-
ment is not strategically exploited by managers, it still might result in fatter-tailed
return distributions if it interrupts the steady flow of information to outside investors.
Discrete information events will be reflected in substantial stock price movements.
This should be true of financial as well as industrial firms.
   Much of the earnings management literature for industrial firms has focused on
the manipulation of accruals: a pattern of departures from a simple statistical model
of “normal” accruals is taken as evidence of earnings management (Healy 1985,
Dechow, Sloan, and Sweeny 1995, Cohen, Dey, and Lys 2005). Hutton, Marcus, and
Tehranian (2009) propose a measure of earnings management based on abnormal
accruals and find that it is in fact associated with tail risk, suggesting that it does
cause information to reach the market in discrete episodes rather than diffusing
steadily and continuously.
   In light of widespread concern over tail risk in financial institutions as well
as the emerging literature linking financial statement opacity to crash risk for
industrial firms, it is interesting to know whether a measure of earnings management,
appropriately defined for banks, would similarly predict increased probability
of tail risk, and in turn whether tail events in stock prices can provide timely
warnings of risk in operating performance. Of course, accruals for banks reflect
different considerations than those that drive accruals for industrial firms. Earnings
management in banks typically is measured by the proclivity to make discretionary
loan loss provisions or by discretionary realizations of security gains or losses.
For example, Cornett, McNutt, and Tehranian (2009) estimate a measure of bank
earnings management using these variables and find that it exhibits the reasonable
properties of being positively related to CEO pay-for-performance sensitivity and
LEE J. COHEN ET AL.     :   173

inversely related to board independence. Adopting a similar approach, we show in
this paper that, like industrial firms, banks also display a positive relation between
apparent earnings management and tail risk. However, in contrast to industrial firms,
bank tail risk typically is not evident in “normal” periods, and therefore is hard
to evaluate even from long sample periods. Nevertheless, earnings management
seems to have a substantial association with tail risk in crisis periods. This pattern
poses a difficult challenge for regulators, who are concerned most of all about large
losses. Our results suggest that earnings management might usefully be considered
a reliable proxy for exposure to large losses during periods of financial stress.
   The remainder of the paper is organized as follows. In Section 1, we briefly review
the literature on tail risk and earnings management. As part of this review, we discuss
how measures of earnings management for industrial firms must be modified for
banks. Section 2 discusses our sample and data sources. Section 3 presents empirical
results. We begin with an analysis and justification of our measure of bank earnings
management, and proceed to demonstrate that this measure and downside risk appear
to be positively related. Finally, Section 4 concludes the paper, where we consider
the policy implications for banks and their regulators.

1. RELATED LITERATURE

1.1 Earnings Management and Crash Risk
   Jin and Myers (2006) present a model in which lack of full transparency concerning
firm performance enables managers to capture a portion of the firm’s cash flows. To
protect their positions, managers may manage earnings by hiding temporary losses
to avoid disclosing negative performance. However, if performance is bad enough,
managers may be unwilling or unable to conceal any more losses. At this point, all of
the previously unobserved negative performance information becomes public at once,
resulting in a firm-specific stock price crash.1 Jin and Myers measure transparency
using characteristics of the broad capital market in which the firm is situated and find
that cross-sectionally (i.e., across countries), less transparent markets exhibit more
frequent crashes. Hutton, Marcus, and Tehranian (2009) further test the Jin and Myers
model by developing a firm-specific measure of earnings management and show that
it predicts higher crash risk at the firm-specific level as well. Consistent with these
results, Kothari, Shu, and Wysocki (2009) provide evidence, based on voluntary
management earnings forecasts, that managers withhold bad news when possible.
   A common measure of earnings management in industrial firms is based on discre-
tionary accruals from the modified Jones (1991) model (Dechow, Sloan, and Sweeney

    1. In the Jin and Myers model, insiders can actually divert cash flow to themselves. This would be
difficult in the banking context, but even here, managers can increase their compensation by artificially
meeting earnings targets. Of special interest is the possibility that a history of nondecreasing earnings that
induces investors to view the bank as low risk may increase the stock price and the value of equity-based
compensation. This risks a sudden dramatic change (and a stock price crash) if the bank is later forced to
report a decrease in earnings, as in Jin and Myers.
174   :   MONEY, CREDIT AND BANKING

1995). Specifically, “normal” accruals are estimated from a simple statistical model
based on firm assets, property, plant, and equipment, and change in sales. “Abnormal”
or discretionary accruals are the residuals between actual accruals and the predicted
accruals from the modified Jones model. Firms with consistently large discretionary
accruals are deemed more likely to be manipulating earnings, or at the very least,
have less transparent financial statements. Healy (1985) concludes that managers
use discretionary accruals to manipulate bonus income. Sloan (1996) shows that the
market seems not to fully recognize the information content of accruals management,
and Dechow, Sloan, and Sweeney (1996) argue that patterns of large discretionary
accruals can be used to detect earnings management. Cohen, Dey, and Lys (2005) find
that abnormal accruals tend to be larger when management compensation is more
closely tied to stock value. Finally, as noted above, Hutton, Marcus, and Tehranian
(2009) find that abnormally large discretionary accruals are associated with crash risk
(which they define as 3-sigma declines in stock price).
   Clearly, measures of abnormal accruals from the Jones (1991) model need to
be modified for banks or other financial institutions that are not engaged in sales-
based businesses. Instead, the focus for banks typically tends to be on loan loss
provisions or the realizations of gains or losses on securities, both of which allow
considerable management discretion. Leeway in these variables may be used to
smooth earnings (Beatty, Ke, and Petroni 2002) or to shore up regulatory capital
(Beaver and Engel 1996, Ahmed, Takeda, and Thomas 1999). Notice that these
goals conflict with transparency by making it more difficult for outside analysts to
discern the true financial condition of the firm. Such practices presumably impede
information flow, and it is at least conceivable that they also make information more
“lumpy,” particularly as the limits of accounting discretion are reached. In the next
subsection, we consider earnings management in banks more closely.

1.2 Earnings Management in Banks
   Loan loss provisions are an expense item on the income statement, reflecting
management’s current assessment of the likely level of future losses from defaults
on outstanding loans. The recording of loan loss provisions reduces net income.
Commercial bank regulators view accumulated loan loss provisions, the loan loss
allowance account on the balance sheet, as a type of capital that can be used to
absorb losses. A higher loan loss allowance balance allows the bank to absorb greater
unexpected losses without failing. Symmetrically, if the loan loss allowance is less
than expected losses, the bank’s capital ratio will overstate its ability to sustain
unexpected losses.
   In addition to loan loss provisions, banks also have discretion in the realization
of security gains and losses (Beatty, Chamberlain, and Magliolo 1995, Beatty
Ke, and Petroni 2002). Unlike loan loss provisions, security gains and losses
are relatively unregulated and unaudited discretionary choices. It is unlikely that
auditors, regulators, or shareholders will subsequently take issue with a manager’s
decision to sell an investment security that happens to increase or decrease earnings.
LEE J. COHEN ET AL.    :   175

Thus, realized security gains and losses represent a second way that management
has been able to smooth or otherwise manage earnings.
   More recently, however, evolving accounting rules, particularly SFAS 157 (which
took effect in November 2007), have increased scrutiny of earnings management
achieved through the recording of gains or losses in the securities portfolio. Fair value
accounting requires assets and liabilities to be listed on a firm’s balance sheet at current
values. Thus, bank earnings can be affected by security sales only to the extent that
values have changed over the very short term. As discussed below, our sample period
runs from 1997 through 2009. Thus, the ability to manage earnings by strategically
realizing securities gains or losses decreases during the period of our analysis.2
   Consistent with these considerations, previous studies have found that banks use
both loan loss provisions and securities gains and losses to manage earnings and
capital levels. Scholes, Wilson, and Wolfson (1990) find that capital positions play a
role in banks’ willingness to realize gains on municipal bonds. Collins, Shackelford,
Wahlen (1995), Beaver and Engel (1996), and Ahmed, Takeda, and Thomas (1999)
find that discretionary accruals are negatively related to capital, although Beatty,
Chamberlain, and Magliolo (1995) reach the opposite conclusion. Wahlen (1994)
shows that managers increase discretionary loan loss provisions when they expect
future cash flows to increase. Finally, Beatty, Ke, and Petroni (2002) find that public
banks are more likely than private ones to use loan loss provisions and realized
securities gains and losses to eliminate small earnings decreases. By and large, both
loan loss provisions and the realization of securities gains and losses appear to be
opportunistically used to manage earnings. Indeed, earnings management may be
used to discreetly smooth earnings over time or to eventually take a “big bath,” that
is, report one drastic earnings decline after hiding a series of smaller declines in
previous years (Arya, Glover, and Sunder 1998, Demski 1998), a pattern consistent
with infrequent but large stock market declines.

2. DATA

   The sample examined in this study includes all publicly traded banks headquartered
in the United States and operating during the 1997 through 2009 period. We use bank
characteristics measured in the decade prior to the financial crisis to predict tail
risk in both the precrisis period, 1997–2006, and the crisis period, 2007–09. All
accounting data are obtained from the Y-9C consolidated Bank Holding Company
(BHC) database, which aggregates bank affiliates and subsidiaries to the bank holding
company level for U.S. domestic banks, found on the Chicago Federal Reserve’s

   2. In addition, in March 2009, ASC320 required financial institutions to recognize other than temporary
impairment (OTTI) on their available-for-sale (AFS) and held-to-maturity (HTM) portfolios. If the loss is
considered temporary, the adjustment is reported in other comprehensive income and may be subsequently
recovered if the value of the investment returns. However, if management considers the loss other than
temporary, the loss is charged to operations and subsequent recoveries of fair value are not recorded in
earnings until the investment is sold. Banks’ treatment of OTTI could be viewed as a way of obscuring
their performance.
176     :   MONEY, CREDIT AND BANKING

TABLE 1
NUMBER OF COMMERCIAL BANKS IN THE SAMPLE

Year                                                                                                                             BHCs

1997                                                                                                                              289
1998                                                                                                                              283
1999                                                                                                                              304
2000                                                                                                                              312
2001                                                                                                                              325
2002                                                                                                                              346
2003                                                                                                                              362
2004                                                                                                                              354
2005                                                                                                                              367
2006                                                                                                                              325
2007                                                                                                                              299
2008                                                                                                                              279
2009                                                                                                                              267
Total                                                                                                                           4,112

NOTE: This table lists the distribution of the sample bank holding companies (BHCs) by year. All accounting data are obtained from FFIEC
Call Reports databases found on the Chicago Federal Reserve’s website (www.chicagofed.org).

website, www.chicagofed.org. Bank stock return data are collected from the Center
for Research in Security Prices (CRSP) database. Table 1 lists the number of publicly
traded banks with available consolidated BHC data by year in our sample. Our
analysis includes a total of 4,112 bank-years.

2.1 Discretionary Loan Loss Provisions and Security Sales
   Variation in bank earnings is driven predominately by the performance of the loan
portfolio. Loans over 90 days past due and still accruing interest as well as loans
no longer accruing interest are observable measures of the current loans at risk of
default. While a portion of the loan loss provisions set aside for these obviously “bad”
loans will be standard and nondiscretionary, there is considerable room for judgment
in the eventual losses that will be realized on these as well as healthier loans. Banks
therefore may manage earnings through allowable discretion in the recording of loan
loss provisions. In principle, each bank manager’s basis for judgment with respect to
these provisions is subject to periodic review by regulators.3 However, in practice,
large banks in particular appear to have considerable discretion: Gunther and Moore
(2003) find that while there are many instances of regulator mandated revisions in
loan loss provisions, only six in their study involve banks with over $500 million in
total assets and only four involve banks that are publicly traded. In addition, as noted
above, banks also have had leeway to manage earnings through the discretionary

    3. Managerial judgment must be based on a “reviewable record” as noted in the Chicago Federal
Reserve’s Micro Data Reference Manual’s data dictionary in its description of Item BHCK4230: Provision
for Loan and Lease Losses. The item should “ . . . include the amount needed to make the allowance for
loan and lease losses . . . adequate to absorb expected . . . losses, based upon management’s evaluation
of the loans and leases that the reporting bank has the intent and ability to hold for the foreseeable future
or until maturity or payoff.”
LEE J. COHEN ET AL.     :   177

realization of security gains and losses, particularly prior to 2007 and the enactment
of SFAS 157.
   The challenge is to devise a measure of discretionary loan loss provisions and
discretionary realization of securities gains and losses and combine them into a
measure of earnings management. We employ the Beatty, Ke, and Petroni (2002)
model of “normal” loan loss provisions using OLS regressions that allow for both
year and regional (specifically, eight regional districts defined by the Comptroller of
the Currency) fixed effects. We estimate the model in the period ending in 2006, the
last full year before the onset of the financial crisis. This ending date ensures that
disruptions to normal bank behavior patterns elicited by the crisis will not affect our
estimates of normal reserving behavior. Their regression model is:4

       LOSSit = αtr + β1 LNASSETit + β2 NPLit + β3 LLRit + β4 LOANRit
                      + β5 LOANCit + β6 LOANDit + β7 LOANAit + β8 LOANIit
                      + β9 LOANFit + εit ,                                                                (1)

where
            i =        bank holding company identifier;
            t =        year (1994 to 2006);
            r =        U.S. Office of the Comptroller of the Currency defined district
                       number;
     α tr        =     fixed effect for region and year;
   LOSS          =     loan loss provisions as a fraction of total loans;
LNASSET          =     the natural log of total assets;
    NPL          =     nonperforming loans (includes loans past due 90 days or more and
                       still accruing interest and loans in nonaccrual status) as a percentage
                       of total loans;
     LLR         =     loan loss allowance as a fraction of total loans;
  LOANR          =     real estate loans as a fraction of total loans;
  LOANC          =     commercial and industrial loans as a fraction of total loans;
  LOAND          =     loans to depository institutions as a fraction of total loans;
  LOANA          =     agriculture loans as a fraction of total loans;
   LOANI         =     consumer loans as a fraction of total loans;
  LOANF          =     loans to foreign governments as a fraction of total loans;
       ε         =     error term.

  The fitted value in equation (1) represents normal loan losses based on the com-
position of the loan portfolio, and therefore, the residual of the regression is taken

    4. Cornett, McNutt, and Tehranian (2009) also employ the Beatty, Ke, and Petroni (2002) model.
However, they use the level of nonperforming loans on the right-hand side, whereas Beatty, Ke, and
Petroni use the change in nonperforming loans. We experimented with both specifications, and found that
it made no difference to our results. We present the results using levels, as it allows our sample to begin a
year earlier.
178   :   MONEY, CREDIT AND BANKING

as the “abnormal” or discretionary component of loan loss provisions.5 However,
because equation (1) models loan loss provisions as a fraction of total loans, while
our measure of earnings management (defined below) is standardized by total assets,
we transform the residual from equation (1) and define our measure of discretionary
loan loss provisions (DISC_LLPit ) as

                                  LOANSit
          DISC LLPit = εit ×               ,                                                              (2)
                                  ASSETSit

where LOANSit = total loans and ASSETSit = total assets of bank i in year t.
  To find discretionary realizations of gains and losses on securities, we again follow
Beatty, Ke, and Petroni (2002). We estimate the following OLS regression over the
precrisis period with time fixed effects. Their model of “normal” realized security
gains and losses (GAINSit ) is

          GAINSit = αt + β1 LNASSETit + β2 UGAINSit + εit ,                                               (3)

where
           i      = bank holding company identifier;
           t      = year (1994 to 2006);
      GAINS       = realized gains and losses on securities as a fraction of beginning-of-
                    year total assets (includes realized gains and losses from available-
                    for-sale securities and held-to-maturity securities);
LNASSET           = the natural log of beginning-of-year total assets;
 UGAINS           = unrealized security gains and losses (includes only unrealized gains
                    and losses from available-for-sale securities) as a fraction of total
                    assets at the beginning of the year;
             ε    = error term.

   The residual from equation (3) is taken as the discretionary component of realized
security gains and losses (DISC_GAINSit ). Panel A of Table A1 in the Appendix
summarizes the variables used to find discretionary and nondiscretionary loan loss
provisions and realized securities gains, Panel B reports descriptive statistics for
all variables in equations (1) through (3), and Panel C presents the results of the
regressions in equations (1) and (3).
   Note that higher levels of loan loss provisions decrease earnings, while higher
levels of realized securities gains and losses increase earnings. Accordingly, we
define bank i’s “discretionary earnings” in year t, DISC_EARNit , as the combined
impact of discretionary loan loss provisions and discretionary realization of securities

   5. This approach is analogous to the common use of the modified Jones model to derive “normal”
accruals for industrial firms and the use of residuals from that model as a measure of discretionary accruals.
Our procedure differs for the crash years, however. As noted above, we apply the coefficients estimated
through 2006 to bank data in 2007–09 to estimate discretionary loan loss provisions during those years.
Therefore, disruptions to bank activities during the crash will not distort our estimates of “normal” bank
behavior.
LEE J. COHEN ET AL.             :   179

TABLE 2
SUMMARY STATISTICS FOR BANKS, PRECRISIS YEARS: 1997–2006

                                                    Mean            Median         Std dev         1st%ile          99th%ile        Observations

Panel A. Descriptive statistics on discretionary earnings variables
DISC_EARN (%)                                     −0.014            0.004          0.370           −1.185             0.858           3,267
DISC_LLP (%)                                      −0.004           −0.023          0.257           −0.481             0.867           3,267
DISC_GAINS (%)                                    −0.018           −0.023          0.281           −0.656             0.764           3,267
Return on assets (%)                              −0.014            0.004          0.370           −1.185             0.858           3,267
Panel B. Descriptive statistics on earnings management variables
EARN_MGT (%)                                         0.601           0.392         0.991             0.069            3.876           3,267
LLP_MGT (%)                                          0.430           0.299         0.501             0.044            2.630           3,267
GAINS_MGT (%)                                        0.380           0.227         0.902             0.029            2.845           3,267
Panel C. Descriptive statistics on bank stock market performance
Worst-week return (%)                             −7.138           −6.398          3.596         −19.778           −2.317             3,267
Residual standard deviation (%)                    3.098            2.883          1.257           1.172            7.612             3,267

NOTE: This table provides summary statistics for all variables used in the analysis. DISC_EARN = discretionary earnings as a percent of
total assets = DISC_GAINS – DISC_LLP, DISC_LLP = discretionary loan loss provisions as a percent of total assets, DISC_GAINS =
discretionary realized security gains and losses as a percentage of total assets. Return on assets = net income in year t/total assets at end of
year t.
   EARN_MGT = |DISC_EARNt−1 | + |DISC_EARNt−2 | + |DISC_EARNt−3 |
   LOAN_MGT = |DISC_LLPt−1 | + |DISC_LLPt−2 | + |DISC_LLPt−3 |
   GAINS_MGT = |DISC_GAINSt−1 | + |DISC_GAINSt−2 | + |DISC_GAINSt−3 |
Panel C statistics on bank performance are summary statistics of annual data for the sample of banks pooled across years. Worst-week return
is lowest bank-specific return over the course of each fiscal year. Residual standard deviation is the standard error of regression residuals from
the estimation of an index model regression, equation (8), of bank returns against the return on the CRSP value-weighted market index and
the Fama–French bank industry index. Each regression is estimated for each bank using weekly observations for the year.

gains or losses:

          DISC EARNit = DISC GAINSit −DISC LLPit .                                                                                           (4)

High levels of DISC_EARN amount to underreporting of loan loss provisions and/or
higher realizations of securities gains, which, ceteris paribus, increase income. Nega-
tive values for DISC_EARN would indicate that loan loss provisions are overreported
and/or fewer security gains are realized, both of which decrease reported operating
income.
   Panel A of Table 2 reports descriptive statistics for each variable in equation (4), es-
timated over the precrisis period, 1997–2006.6 The average level of both discretionary
loan loss provisions and realized securities gains (both as a percent of assets) are mea-
sured as departures from normal behavior (i.e., as regression residuals), and therefore
by construction, are virtually zero.7 However, there is meaningful variation in these

   6. The exclusion of 2007–09 from these summary statistics explains why there are 4,112 banks in
Table 1, but only 3,267 observations in Table 2. Also, while the behavioral equations (1) and (3) are
estimated over the 1994–2006 period, the final sample period does not begin until 1997 because some of
the variables used in the following regression analysis entail 3-year lagged values (see below).
   7. The average value is not precisely zero because, while we estimate equations (1) and (3) over the
1994–2006 period, the final sample begins in 1997 as the earnings management variables are defined as
3-year moving sums of lagged values.
180   :   MONEY, CREDIT AND BANKING

2.0%
1.8%
1.6%
1.4%
1.2%
1.0%
0.8%
0.6%
0.4%
0.2%
0.0%
          1997   1998     1999     2000    2001     2002    2003     2004    2005     2006     2007    2008     2009

                                 FIG. 1. Standard Deviation of Discretionary Earnings.
NOTE: Cross-sectional standard deviation of discretionary earnings, DISC_EARN, across the sample of banks in each
year. Discretionary earnings equal discretionary realization of securities gains or losses minus discretionary loan loss
provisions, each expressed as a percentage of total assets.

numbers. Discretionary loan loss provisions, DISC_LLP, in the precrisis period range
from a 1st percentile value of −0.481% to a 99th percentile value of 0.867% of assets,
with a standard deviation (across banks and time) of 0.257% of assets. The corre-
sponding range for realized securities gains is from −0.656% to 0.764% of assets,
with a standard deviation of 0.281% of assets. The standard deviation of discretionary
earnings, DISC_EARN, is 0.370% of assets, indicating that a nontrivial portion of
the variation in reported bank performance (the standard deviation of bank ROA is
0.614%) is due to management’s discretionary accounting and security sales choices.
   Figure 1 plots the standard deviation across banks of DISC_EARN in each year.
Notice the dramatic increase in the cross-sectional standard deviation of discretionary
earnings in the 2007–09 period. This may indicate that normal bank behavior as
expressed in equation (4) significantly changes during the crisis. We therefore will
focus primarily on patterns computed prior to 2007. The next section offers further
evidence on accounting discretion.

2.2 Earnings Management
   Table 3 examines the time-series properties of discretionary earnings,
DISC_EARN, as well as its two components, discretionary loan loss provi-
sions, DISC_LLP, and discretionary realizations of gains or losses on securities,
DISC_GAINS. We regress each of these variables on their own past values in the
previous 3 years. We estimate the relation over the precrisis period, 1997–2006, be-
cause Figure 1 suggests that the extreme events of the crisis years might disrupt the
patterns that characterized each bank in the previous decade.
LEE J. COHEN ET AL.            :   181

TABLE 3
TIME-SERIES BEHAVIOR OF COMPONENTS OF DISCRETIONARY BANK EARNINGS

Dependent variable                          Explanatory variable                                Coefficient                         t-statistic

Panel A. Discretionary earnings
DISC_EARN                                   DISC_EARN(−1)                                          0.105                              5.65
                                            DISC_EARN(−2)                                        −0.054                              −2.79
                                            DISC_EARN(−3)                                        −0.150                              −7.61
                                            Observations                                          3,267
                                            Fixed effects                                           Y
Panel B. Discretionary loan loss provisions
DISC_LLP                                    DISC_LLP(−1)                                           0.210                             11.30
                                            DISC_LLP(−2)                                         −0.093                              −4.80
                                            DISC_LLP(−3)                                         −0.111                              −5.70
                                            Observations                                          3,267
                                            Fixed effects                                           Y
Panel C. Discretionary securities gains/losses
DISC_GAINS                                  DISC_GAINS (−1)                                        0.027                              1.40
                                            DISC_GAINS (−2)                                      −0.084                              −4.18
                                            DISC_GAINS (−3)                                      −0.196                              −9.67
                                            Observations                                          3,267
                                            Fixed effects                                           Y

NOTE: Each component of earnings management is regressed on its own lagged values. Observations are annual over the period 1997–2006.
Discretionary items are estimated as residuals from equations that predict loan loss provisions and realized securities gains and losses based
on bank characteristics (see Beatty, Ke, and Petroni 2002). The models of “normal” loan loss provisions and realized securities gains and
losses are contained in the Appendix. These regressions are estimated with bank and year fixed effects.

   Panel A of Table 3 shows that in the short term (i.e., at a 1-year lag), discretionary
earnings exhibit positive serial correlation, with a positive and statistically significant
coefficient (0.105) on the 1-year lagged value. However, at longer lags of 2 or 3
years, this relation reverses. The coefficients at these lags (−0.054 and −0.150,
respectively) are negative, highly significant, and of considerably greater combined
magnitude than the coefficient on the 1-year lag. When we decompose discretionary
earnings into its two components, we find precisely the same patterns (Panels B and
C). Both discretionary loan loss provisions as well as discretionary realizations of
securities gains or losses show the same positive serial correlation at 1-year horizons,
but negative and larger combined serial correlations at the 2- and 3-year horizons. This
pattern suggests that discretionary contributions to earnings due either to “abnormal”
loan loss provisions or to security sales show a reliable tendency to reverse in later
years.
   If managers consistently employ unbiased estimates of future loan losses to deter-
mine the proper level of current reserves, we would find no time-series dependence
in the discretionary loan loss series. The significant time-series patterns that actually
characterize the data suggest that loan loss provisions are subject to strategic con-
siderations. Managers may use their discretion in choosing loan losses to paint some
desired picture of the firm. But over time, as accumulated loan loss provisions must
be reconciled to actual loss experience, those discretionary choices must be reversed.
182   :   MONEY, CREDIT AND BANKING

Similarly, the reversal patterns in realized gains or losses on security sales suggest
that managers selectively choose securities to sell based in part on the contribution
to current earnings, leaving them with a preponderance of offsetting gains or losses
on future sales.
   The pattern revealed in Table 3 is highly reminiscent of the literature on discre-
tionary accruals that has been used to examine earnings management in industrial
firms. There too we observe some short-term momentum in discretionary accruals
followed by reversals. For example, Dechow, Sloan, and Sweeney (1996) examine
the pattern of discretionary accruals for known earnings manipulators, specifically,
firms subject to enforcement actions by the SEC. Discretionary accruals gradually
increase as the alleged year of earnings manipulation approaches and then exhibit a
sharp decline. The initial increase in discretionary accruals is consistent with manip-
ulation to increase reported earnings: the decline, with the reversal of prior accrual
overstatements. Our results on discretionary choices for banks similarly demonstrate
a pattern of reversals that undoes prior distortion of reported earnings.
   Therefore, we define earnings management, EARN_MGT, as the 3-year moving
sum of the absolute value of DISC_EARN. Although managers may prefer account-
ing choices that increase earnings, following Hutton, Marcus, and Tehranian (2009),
who look at earnings management and crash risk in industrial firms, we use absolute
values of discretionary earnings rather than signed values. Both positive and negative
abnormal earnings may indicate a tendency to manage earnings: discretionary ac-
counting choices that artificially enhance reported earnings in one period eventually
must be reversed. Like them as well, we use the 3-year moving sum (instead of a
1-year value) to capture the multiyear effects of discretionary choices because the
moving sum is more likely to reflect sustained, underlying bank policy.

 EARN MGT = |DISC EARNt−1 | + |DISC EARNt−2 | + |DISC EARNt−3 |.                      (5)

   We also break earnings management into its components, loan loss provisions and
realized securities gains and losses, to see whether one or the other of these sources
of discretionary behavior has greater association with tail risk. Therefore, we also
evaluate the following 3-year moving sums:

  Loan loss management: LLP MGT = |DISC LLPt−1 | + |DISC LLPt−2 |
                                            + |DISC LLPt−3 |.                         (6)

  Securities gains/losses management:

      GAINS MGT = |DISC GAINSt−1 | + |DISC GAINSt−2 | + |DISC GAINSt−3 |.
                                                                                       (7)

   Panel B of Table 2 presents descriptive statistics for these variables in the precrisis
years. The mean value of EARN_MGT (computed over the preceding 3 years, t − 3
to t − 1) is 0.601% of assets. The mean value of LLP_MGT is 0.430% of assets, and
LEE J. COHEN ET AL.    :   183

the mean of GAINS_MGT is 0.380%.8 During the period, mean return on assets is
1.090%. Therefore, these values are appreciable fractions of typical ROA.

2.3 Tail Risk
   We are ultimately concerned with tail risk, specifically, the impact of cross-
sectional variation in earnings management on the incidence of extreme negative
returns. Therefore, we need to net out that portion of returns attributable to common
market factors and industry effects. Bank-specific returns are defined as the residuals
from an expanded index model with both market and bank-industry factors. We esti-
mate equation (8) each bank-year using weekly data, and allow for nonsynchronous
trading by including two lead and lag terms for the market and industry indexes
(Dimson 1979)9

      r j,t = α j + β1, j rm,t−2 + β2, j ri,t−2 + β3, j rm,t−1
              + β4, j ri,t−1 + β5, j rm,t + β6, j ri,t + β7, j rm,t+1
              + β8, j ri,t+1 + β9, j rm,t+2 + β10, j ri,t+2 + ε j,t ,                                (8)

where rj,t is the stock market return of bank j in week t, rm,t is the CRSP value-
weighted market index, and ri,t is the Fama–French value-weighted bank industry
index. The residual of equation (8), εj,t , is the bank-specific return in each week. Our
bank-specific crashes therefore represent extreme price movements over and above
those due to market-wide and industry-wide events.
   Summary statistics for worst-week bank-specific returns and residual risk in the
precrisis years appear in Panel C of Table 2. The average residual standard deviation
of bank-specific stock returns in this period is 3.098%. Figure 2 shows that this value
is fairly consistent over the precrisis period. Under the assumption that bank-specific
returns are normally distributed, the expected value of the worst-week bank-specific
return in a sample of 52 weekly observations would be 2.26 standard deviations below
the mean; with a mean of zero and standard deviation of 3.098% for the precrisis
period, this would imply an expected worst-week return of −2.26 × 3.098% =
−7.00%. In fact, the sample-average worst-week return in the precrisis period is
−7.138%, suggesting that, at least prior to the crisis, fat-tailed distributions are not
an issue.
   However, Figure 2 demonstrates that residual standard deviations rise sharply with
the onset of the crisis. As bank-specific returns already control for market and industry
performance, this pattern indicates that banks are differentially affected by the crisis,
leading to greater within-industry dispersion of returns.
   Part of the increase in cross-sectional dispersion, of course, is due to the sharp
increase in the incidence of banks that suffer a crash during the financial crisis.

  8. These values do not add up because the absolute value of a sum is not the sum of absolute values.
  9. Results using only one lead and lag of weekly returns were nearly identical.
184                                            :    MONEY, CREDIT AND BANKING

                                               8%
Residual standard deviation of weekly return

                                               7%

                                               6%

                                               5%

                                               4%

                                               3%

                                               2%

                                               1%

                                               0%
                                                     1997 1998            1999 2000 2001          2002 2003          2004 2005       2006 2007 2008              2009

                                                                    FIG. 2. Standard Deviation of Bank-Specific Weekly Rates of Return.
NOTE: Standard error of regression residuals from estimation of index model regression, equation (8), of bank returns
against the return on the CRSP value-weighted market index and the Fama–French bank-industry index. Each regression
is estimated for each bank using weekly observations for the year. The residual standard deviations are averaged across
banks in each year.

TABLE 4
INCIDENCE AND AVERAGE MAGNITUDE OF WEEKLY CRASHES

Year                                                 Percentage crashes      Mean crash (measured in standard deviations)   Median crash (measured in standard deviations)

1997                                                      3.8%                                −3.40                                           −3.19
1998                                                      8.1%                                −3.42                                           −3.32
1999                                                     11.2%                                −3.46                                           −3.28
2000                                                     12.8%                                −3.68                                           −3.55
2001                                                      7.7%                                −3.42                                           −3.27
2002                                                     10.4%                                −3.52                                           −3.52
2003                                                     10.8%                                −3.65                                           −3.43
2004                                                      9.3%                                −3.56                                           −3.45
2005                                                     10.6%                                −3.60                                           −3.51
2006                                                     11.7%                                −3.51                                           −3.34
2007                                                     21.7%                                −4.00                                           −3.66
2008                                                     74.2%                                −5.61                                           −4.63
2009                                                     81.6%                                −5.89                                           −5.18

NOTE: The percentage of crashes equals the fraction of banks with at least 1 week in the year with bank-specific returns less than 3.09
standard errors below the mean. The mean (median) crash is the average (median) across banks of the weekly stock return during crash weeks,
expressed as a multiple of the bank-specific standard deviation.

Table 4 presents annual measures of crash propensity. We measure residual standard
deviation for each bank in each year.10 If returns in the coming year are normally

    10. Once we reach the crisis years, however, bank-specific crashes will have large impacts on the
estimate of cross-sectional dispersion in that year. To avoid the resulting overestimate in residual standard
LEE J. COHEN ET AL.     :   185

distributed, only 0.1% of banks in any week would be expected to exhibit bank-
specific returns less than 3.09 standard deviations below their mean value, and in
any year, only 1 − (1 − 0.001)52 = 0.0507 or 5.07% of banks would experience
a week with returns below this level. In fact, crash incidence exceeds this value.
Table 4 shows for each year the actual percentage of banks with firm-specific returns
in at least 1 week falling below this cutoff. The percentage in the precrisis years
is generally between 5% and 10%, but it balloons to 74.2% in 2008. The negative
returns corresponding to these crashes are quite large; in the precrisis period, the
median bank-specific loss in a crash week is roughly 3.39 times the weekly residual
standard error from equation (8), or about 10.5%, while in the 2007–09 period the
median loss in a crash week is 4.49 times the standard error.

3. EMPIRICAL RESULTS

3.1 Crash Risk
   Table 5 presents an analysis of the association between crash risk and earnings
management. The table reports probit (panel) regressions for the likelihood of a bank-
specific crash in any year. The dependent variable (indicating a crash) is assigned
a value of 1 if in any week in that year the bank-specific return is less than −3.09
times the bank-specific standard deviation. The right-hand-side variables of interest
are EARN_MGT or, in alternative specifications, its two components, LLP_MGT
or GAINS_MGT. These are winsorized at their 1st and 99th percentile values. We
also interact these explanatory variables with a financial crisis dummy to allow them
to have different effects during the crisis period. The additional controls are total
bank assets, bank capital ratio,11 and the Amihud (2002) measure of stock illiquidity.
Amihud’s measure equals the ratio of the absolute value of daily stock returns divided
by daily dollar trading volume, averaged over the year. Less liquid stocks may be
more prone to tail events, as they are less able to absorb sudden shifts in demand.
The regressions are estimated with year fixed effects.12
   Column (1) of Table 5 employs EARN_MGT as the right-hand-side variable,
while column (2) breaks out earnings management into its two component terms. In
columns (1) and (2), the coefficients on these terms are fixed over the entire sample
period. In these columns, earnings management as a whole and more particularly dis-
cretionary loan loss provisions are marginally significant. However, in columns (3)
and (4), we introduce crisis-period interaction terms that allow earnings management

deviation, we set residual standard deviation for 2007–09 equal to the firm’s average value in the precrisis
years.
    11. The capital ratio for each bank is defined as (Tier 1 capital allowable under the risk-based capital
guidelines) / (average total assets net of deductions), as reported on the bank’s consolidated Y-9C Report.
In turn, total bank assets equal all foreign and domestic assets reported on each bank’s consolidated Y-9C
Report.
    12. Including bank fixed effects would result in biased coefficient estimates (Stata 2009, p. 410), so
we exclude them in Table 5. Nevertheless, in unreported regressions, we experimented with bank fixed
effects and found that they had almost no impact on our estimates.
186    :   MONEY, CREDIT AND BANKING

TABLE 5
CRASH INCIDENCE AS A FUNCTION OF BANK EARNINGS MANAGEMENT

                                                     (1)                        (2)                        (3)                         (4)

EARN_MGT                                          8.215*                                                2.566
  (t-statistic)                                  (1.935)                                               (0.415)
  (Economic magnitude)                            0.01969                                               0.00655
EARN_MGT * CRISIS                                                                                      22.699**
                                                                                                       (2.219)
                                                                                                        0.08882
LLP_MGT                                                                    11.860**                                               −1.280
                                                                            (2.052)                                              (−0.148)
                                                                             0.02088                                              −0.00269
GAINS_MGT                                                                  −0.529                                                   2.390
                                                                          (−0.067)                                                 (0.252)
                                                                           −0.00078                                                 0.00437
LLP_MGT * CRISIS                                                                                                                  62.140***
                                                                                                                                   (3.627)
                                                                                                                                    0.16432
GAINS_MGT * CRISIS                                                                                                                −3.405
                                                                                                                                 (−0.234)
                                                                                                                                  −0.00644
Total assets (t − 1)                              0.088                      0.119                      0.070                       0.114
                                                 (0.243)                    (0.328)                    (0.193)                     (0.304)
                                                  0.00036                    0.00049                    0.00033                     0.00058
Capital ratio (t − 1)                           −1.475                     −1.080                     −2.099                      −0.526
                                               (−1.175)                   (−0.882)                   (−1.387)                    (−0.410)
                                                −0.00772                   −0.00566                   −0.01251                    −0.00344
Amihud measure (t − 1)                          −0.782                     −0.825                     −0.615                      −0.596
                                               (−0.973)                   (−1.028)                   (−0.763)                    (−0.728)
                                                −0.00410                   −0.00563                   −0.00478                    −0.00508
Firm fixed effects                                  N                          N                          N                           N
Year fixed effects                                  Y                          Y                          Y                           Y
N                                                 4,112                      4,112                      4,112                       4,112
Pseudo R2                                         0.278                      0.278                      0.280                       0.282

NOTE: Probit regressions, with dependent variable equal to 1 if the lowest bank-specific return in the year is worse than 3.09 standard
deviations below zero. Sample period = 1997–2009. Bank specific returns are calculated as residuals from estimation of an index model
regression, equation (8), of weekly bank returns against the return on the CRSP value-weighted market index and the Fama–French bank
industry index. Earnings management variables are winsorized at 1st and 99th percentile values. Regressions are estimated with year fixed
effects. Economic magnitude equals the predicted change in the probability of a crash week occurring during the year given a change in the
right-hand-side variable from the 10th percentile in the sample distribution to the 90th percentile. *significant at 10% level; **significant at
5% level; ***significant at 1% level.

to have different effects in the pre- and postcrisis periods. In this specification, there
is no apparent relationship between earnings management and crash likelihood in the
precrisis years (the coefficients on EARN_MGT or its components are all statistically
insignificant at the 5% level in columns (3) and (4)), but the interaction terms between
the crisis dummy and both earnings management and loan-loss provisions are statisti-
cally significant. For example, the EARN_MGT * CRISIS interaction term in column
(3) has a t-statistic of 2.219 and a coefficient of 22.699. Most of the power of total
EARN_MGT clearly comes from management of loan loss provisions rather than
from securities gains or loss management. The LLP_MGT * CRISIS interaction term
in column (4) has a t-statistic of 3.627 with a positive coefficient, 62.140. In contrast,
securities gains or losses management apparently has little relation to crash propen-
sity. Even in the crisis, it is statistically insignificant, with the GAINS_MGT * CRISIS
LEE J. COHEN ET AL.     :   187

term receiving a t-statistic of only 0.234. This may be due to the fact that (as discussed
above), during the latter part of our sample period, SFAS 157 significantly limited the
ability of banks to use security portfolio gains and losses as a tool to manage earnings.
   The economic impacts in Table 5 equal the increase in crash probability during
the year corresponding to an increase in each variable from the 10th percentile of the
sample distribution to the 90th percentile. This is analogous to a shift of the right-
hand-side variable from the middle of the first quintile of its distribution to the middle
of the fifth quintile, and thus is comparable to a common “(5) − (1) difference.” The
impact of EARN_MGT during the crisis is economically large, 8.88%, and the impact
of LLP_MGT is even higher, 16.43%. The latter value is between one-fifth and one-
quarter of the unconditional probability of a crash in the crisis years (see Table 4).
By way of comparison, Hutton, Marcus, and Tehranian (2009) find that a comparable
increase in earnings management in their sample of industrial firms increases crash
likelihood by around one-sixth of the unconditional probability of a crash. Crash
sensitivities for this sample of banks are thus a bit stronger than the corresponding
values for industrial firms.
   The control variables, total assets, capital, and liquidity, all are statistically in-
significant in explaining crash likelihood. In sum, it appears from Table 5 that banks
engaging in greater earnings management are more likely to experience crashes dur-
ing the crisis, even though such crash risk does not make itself evident in the precrisis
years.
   Table 6 presents similar regressions, but instead of a 0–1 crash indicator on the
left-hand side, we use a 0–1 jump indicator, where a jump is defined as an increase
in stock price of a least 3.09 standard deviations. This allows us to test whether
bank earnings management is related to skewness (specifically, negative crashes) or
kurtosis (fat tails on both sides of the return distribution). Table 6 is notable for what
it does not show. With only one exception, neither earnings management nor either
of its components is significant in any of the specifications. We conclude from these
results that while crash risk is reliably higher for banks that manage earnings more
aggressively, jump potential is not.
   To test this more formally, we compute chi-square tests for the equality of the
regression coefficients on EARN_MGT in predicting crash versus jump probabili-
ties.13 The chi-square statistic for such equality is 25.3, which allows us to reject
the hypothesis of equality at a 0.00% level. A similar test for the (joint) equal-
ity of the coefficients on the components of earnings management, LLP_MGT and
GAINS_MGT, yields a chi-square of 14.7 and a p-value of 0.07%.

   13. This test requires that the coefficients for jumps versus crashes be nested in a single regression
framework, which allows us to impose a constraint that the coefficients are equal. Therefore, we compute
these chi-square statistics using a multinomial probit regression allowing for three states: crashes, jumps,
or neither event.
188    :   MONEY, CREDIT AND BANKING

TABLE 6
JUMP INCIDENCE AS A FUNCTION OF BANK EARNINGS MANAGEMENT

                                                     (1)                        (2)                         (3)                        (4)

EARN_MGT                                           2.807                                                 1.134
  (t-statistic)                                   (0.899)                                               (0.318)
  (Economic magnitude)                             0.01036                                               0.00398
EARN_MGT * CRISIS                                                                                        9.191
                                                                                                        (1.287)
                                                                                                         0.04950
LLP_MGT                                                                     10.488**                                                 7.590
                                                                            (2.127)                                                 (1.391)
                                                                             0.02841                                                 0.02039

GAINS_MGT                                                                  −8.715                                                −10.263
                                                                          (−1.320)                                               (−1.352)
                                                                           −0.01979                                               −0.02397
LLP_MGT * CRISIS                                                                                                                  22.761
                                                                                                                                   (1.375)
                                                                                                                                    0.07696
GAINS_MGT * CRISIS                                                                                                                11.886
                                                                                                                                   (0.961)
                                                                                                                                    0.02876
Total assets (t − 1)                            −0.587***                  −0.553***                   −0.597***                  −0.575***
                                               (−3.891)                   (−3.913)                    (−3.931)                   (−4.206)
                                                −0.00370                   −0.00349                    −0.00384                   −0.00376
Capital ratio (t − 1)                             0.044                      0.242                     −0.190                       0.189
                                                 (0.029)                    (0.196)                   (−0.115)                     (0.141)
                                                  0.00035                    0.00195                   −0.00156                     0.00158
Amihud measure (t − 1)                            0.554                      0.412                       0.644                      0.545
                                                 (0.665)                    (0.500)                     (0.766)                    (0.653)
                                                  0.00446                    0.00433                     0.00689                    0.00594
Firm fixed effects                                  N                          N                           N                          N
Year fixed effects                                  Y                          Y                           Y                          Y
N                                                 4,112                      4,112                       4,112                      4,112
Pseudo R2                                         0.278                      0.278                       0.280                      0.282

NOTE: Probit regressions, with dependent variable equal to 1 if the lowest bank-specific return in the year is more than 3.09 standard deviations
above zero. Sample period = 1997–2009. Bank-specific returns are calculated as residuals from estimation of an index model regression,
equation (8), of weekly bank returns against the return on the CRSP value-weighted market index and the Fama–French bank industry index.
Earnings management variables are winsorized at 1st and 99th percentile values. Regressions are estimated with year fixed effects. Economic
magnitude equals the predicted change in the probability of a jump week occurring during the year given a change in the right-hand-side
variable from the 10th percentile in the sample distribution to the 90th percentile. *significant at 10% level; **significant at 5% level;
***significant at 1% level.

3.2 Stock Price Crashes versus Operational Risk
   As we acknowledge above, regulators may be less concerned with stock price risk
per se than with the underlying operating performance of a bank. Moreover, stock
price movements may reflect variables such as short-term fluctuations in risk premia
that do not reflect on operational performance. On the other hand, large stock price
drops may in fact signal a market expectation of deteriorating performance, and this
would concern regulators. We address these issues by examining full-year stock price
performance, implied volatilities, and changes in bank return on assets.
   First, we consider the relation between earnings management and annual returns
(rather than weekly crashes) during the crisis. Stock returns over a full year may be
more reflective of persistent underlying conditions than weekly returns, even if they
are extreme. We calculate each bank’s annual firm-specific return by compounding its
LEE J. COHEN ET AL.        :   189

14%
                                                                                                                  13.0%
12%

10%

  8%
                                                                                                          7.0%
  6%

  4%                                3.9%
                           2.4%
  2%                                        1.7%              1.3%
         1.2%                                                          0.8%     1.0%
                  -0.1%                               0.1%                              0.3%     0.3%
  0%
         1997     1998     1999     2000     2001    2002     2003     2004     2005    2006     2007     2008     2009
 -2%
p-val 0.028 0.819 0.029 0.019 0.004 0.836 0.111 0.199 0.072 0.468 0.598 0.006 0.002

                                   FIG. 3. Earnings Management and Annual Returns.
NOTE: In each year, banks are ranked by earnings management and sorted into five quintiles. The difference in annual
firm-specific returns between quintile (1) and quintile (5) banks are presented for each year. Annual firm-specific returns
are computed by compounding weekly idiosyncratic returns within bank-years. A positive value indicates that the most
aggressive earnings-management quintile outperformed the least aggressive quintile. The p-values are presented for the
difference between the fifth and first quintile annual returns in each year.

weekly idiosyncratic returns. We then rank banks by earnings management and assign
each bank to an earnings management quintile. Finally, we compute the difference
in the average annual firm-specific return between the banks in the upper and lower
earnings management quintiles. As shown in Figure 3, annual returns also support the
hypothesis that earnings management is associated with greater downside risk during
the crisis years, and that this risk differential is substantial. That is, until the crisis, the
difference in the average annual firm-specific returns between banks in the upper and
lower earnings management quintiles is generally small and statistically insignificant.
But in 2008 and 2009, the difference spikes. The most aggressive earnings managers
underperform the least aggressive ones by highly substantial margins, 7.0% and
13.0% in those 2 years. These large economic differences are also highly statistically
significant, with p-values of 0.6% and 0.2% in the 2 years. Interestingly, the other
years in which bank earnings management is correlated with underperformance are
the years of financial turbulence corresponding to the final run-up and then collapse
of the dot-com sector in the 1999–2001 period.
   These results reinforce the conclusion of the probit regressions that earnings man-
agement is related to substantial downside exposure, not to fat tails more generally.
They also imply that crash weeks are not as a rule followed by a stock price recovery.
High earnings management banks show greater crash risk during the crisis as well
as considerable sustained underperformance throughout the crisis. The consistency
of the crash risk probit regressions and these annual return differentials suggest that
the stock price declines reflect a reassessment of underlying bank prospects rather
than short-lived financial market fluctuations due, for example, to high-frequency
variation in risk premia.
190   :   MONEY, CREDIT AND BANKING

TABLE 7
INCREASE IN IMPLIED VOLATILITY OF BANKS AS A FUNCTION OF EARNINGS MANAGEMENT AND ITS COMPONENTS

                                              Mean implied                Mean implied
                                                volatility                  volatility
                                              Jan. 31, 2007       N       Jan. 30, 2009        N       Difference         t-stat (p-value)

Panel A
EARN_MGT [bottom tercile]                        0.199           12           0.815           12          0.616
EARN_MGT [top tercile]                           0.178           18           0.929           18          0.751
Diff-in-diff                                                                                              0.135         1.597 (0.121)

Panel B
LLP_MGT [bottom tercile]                         0.180           17           0.929           17        0.749
LLP_MGT [top tercile]                            0.195           15           0.730           15        0.535
Diff-in-diff                                                                                           −0.213          3.546 (0.0013)

Panel C
GAINS_MGT [bottom tercile]                       0.193           9            0.806            9          0.612
GAINS_MGT [top tercile]                          0.191           23           0.953           23          0.762
Diff-in-diff                                                                                              0.150        −1.638 (0.112)

NOTE: In this table, we rank banks by earnings management and then assign them to terciles. The mean implied volatility of at-the-money call
options for each group is computed precrisis (January 31, 2007) and mid-crisis (January 30, 2009). The difference-in-difference is positive
when high earnings management banks demonstrate greater increases in implied volatility than low earnings management banks.

   Further corroboration for the view that the higher rate of stock price crashes for
more aggressive earnings managers is due to a reassessment of their prospects is
found in the positive correlation between earnings management and loan loss pro-
visions during the crisis years. That correlation is 0.324, indicating that loan loss
provisions during the crisis increased with the aggressiveness of earnings manage-
ment as measured before the crisis. In other words, compared to less aggressive
earnings managers, aggressive banks revealed during the crisis greater negative in-
formation about the quality of their loan portfolios. In contrast, earnings management
and loan loss provisions in the precrisis years are nearly unrelated, with a correlation
coefficient of only 0.035.14
   To examine whether the greater stock price decline of high-earnings management
banks documented in Figure 3 might be related to increases in risk and therefore
risk premia, Table 7 examines the increase in implied volatility from the precrisis
period to the crisis period as a function of bank earnings management.15 If the
implied volatilities of aggressive earnings managers increase by more than those of

    14. Symmetrically with the positive correlation between earnings management and loan loss provisions
in the crisis years, one may have expected negative correlation in the precrisis years, with more aggressive
earnings managers understating potential loan loss exposure. If high earnings management banks made
riskier loans, however (which seems to be the case based on loan loss provisions during the crisis), the
lack of correlation between loan loss provisions and earnings management would imply that there was in
fact underreserving in the precrisis years, since those riskier loans should have elicited higher reserves.
    15. We collect these implied volatilities from the OptionMetrics database. We average the implied
volatilities of the closest-to-the-money 30-day call and put options.
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