Institutional Investors and Earning Management by Bank Holding Companies

Earning management (EMGT) by firms heightens information asymmetry between corporate insiders on the one side and outside investors and regulators on the other, leading the latter to make wrong investment and regulatory decisions, respectively. This issue is of special interest in the banking industry because the highly regulated, heavily leveraged and opaque character of this industry strengthens the incentives driving EMGT. We explore the role of institutional investors as a source of market discipline in constraining EMGT by bank holding companies (BHCs). While regulations are intended to mitigate opportunism such as EMGT, they may lead banks to engage in EMGT to avoid regulatory intervention. Given the unique nature of bank assets/liabilities (loans and deposits), their tools of EMGT are also dissimilar to those used by non-banking firms. We propose that ownership by monitoring institutions (institutional investors with large and long-term stakes and independence from managers), is associated with less EMGT because these institutions have greater incentives to monitor their investees than other owners. Using a sample of 497 BHCs with 3131 BHC-year observations over the 1996-2012 period, we find that EMGT by BHCs is negatively associated (unassociated) with ownership by monitoring (non-monitoring) institutions. We also find that institutional investor monitoring is stronger for larger and more volatile banks where information asymmetry tends to be greater. Our findings provide support for the idea that regulators should allow or even facilitate ownership by monitoring institutional owners as a substitute or complement to regulation. Our results are robust to alternative ownership measures and accounting for endogeneity.