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| Climate Risk and Bank Earnings Management from the Perspective of Financial Regulation |
| SHEN Yu, SHE Kaiwen, XU Xian
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School of Finance, Southwestern University of Finance and Economics;
School of Economics, Fudan University |
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Abstract Climate change has adverse effects on the banking system, and interest in climate change in banking and finance has increased in recent years. In February 2020, the Basel Committee on Banking Supervision established the Task Force on Climate-related Financial Risks. However, climate-related financial risks in the Chinese banking system have not received much attention, even though China is one of the countries most severely affected by climate disasters.
In this study, we extend the literature by examining whether climate change is associated with banks' discretionary loan loss provisions. Furthermore, we suggest that earnings management may be a consequence of climate-related financial risks in the banking industry. Specifically, we hypothesize that in the presence of climate change risk, a bank's management team has a better excuse to manipulate earnings via loan loss provisions. First, a bank's management team is motivated to manipulate earnings. Due to the separation of ownership and control, a bank's management team has sufficient incentives to manipulate earnings to satisfy their own interests. Second, from the perspective of the costs and benefits of bank earnings management, manipulation of earnings can result in significant regulatory costs. We argue that the regulatory costs of earnings management decrease in the presence of climate change risk, thus increasing the benefits of earnings management, leading a bank's management team to increase their earnings management behavior. On the one hand, due to information asymmetry between regulators and banks, it is difficult for regulators to estimate the actual impact of climate risk on banks and how much loan loss provision banks should set aside. On the other hand, the change in financial performance due to climate risk is not related to a bank management team's ability, and thus there is no reputational cost suffered by a management team's manipulation of their bank's earnings in the name of climate risk. Therefore, it is reasonable to manipulate bank earnings in the presence of opportunism of bank managers and climate risk.
We use annual reports from 2007 to 2019 to construct a comprehensive sample of China's local commercial banks. First, we document a positive link between climate change and banks' discretionary loan loss provisions after controlling for bank fixed effects and year fixed effects. The effects are statistically and economically significant. We also exclude an alternative explanation and conduct a series of robustness tests. Second, we find that decreased manipulation costs for a bank's management team and a lack of bank disclosure of climate risk information lead to banks engaging in earnings management in the name of climate risk. Specifically, decreased manipulation costs are manifested in the fact that current climate-risk shocks do not negatively affect a management team's compensation in the current period. In addition, banks' lack of information disclosure makes it difficult for external supervisors to detect banks' earnings management in the name of climate risk. Third, we find that this positive association is nonsignificant for banks with low earnings growth rates but significant for banks with high earnings growth rates. Consistent with “cookie jar reserves” practice, we find that earnings hidden by a bank during natural disasters are released by the bank in the first year after the natural disaster to achieve income smoothing. Finally, we find that banks that face increases in regulation from the China Banking Regulatory Commission and China Securities Regulatory Commission at the time of listing cease participating in earnings management practices in the name of climate change.
In this study, we contribute to the literature in several ways. First, we complement the literature on climate change impacts—which focuses on the impact of climate change on individuals and firms—by exploring the impact of climate-related financial risks on bank earnings management. Second, we extend the literature on the identification and motivation of bank earnings management. To the best of our knowledge, this is the first study to introduce a climate change-induced motivation for bank earnings management. This addresses the issue of whether and to what extent climate-related financial risks affect financial reporting quality. Finally, our study has significant policy implications. In November 2021, the Basel Committee on Banking Supervision issued a public consultation on principles for the effective management and supervision of climate-related financial risks. This consultation seeks to promote a principles-based approach to improving banks' risk management and supervisors' practices related to climate-related financial risks. Nevertheless, little attention has been paid to the climate-related financial risks that China may encounter in addressing climate change. The findings of the current study echo public consultation on climate-related financial risks and provide insights not only to academics but also to the banking industry and regulators in China.
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Published: 03 August 2023
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