Effects of declining bank health on borrowers’ earnings quality: evidence from the European sovereign debt crisis

This study investigates whether the deterioration of banks’ financial health affects borrowers’ earnings quality. To examine this issue, we consider the European sovereign debt crisis a shock to the health of certain European banks; these banks were affected and tightened their lending conditions relatively more than nonexposed banks during the crisis. This setting represents an exogenous shock to German nonfinancial firms that were not directly affected by the crisis. We use a difference-in-differences research design, and German firms with lending relationships with nonexposed banks are used as controls. Using various discretionary accrual measures and a timely loss recognition concept to evaluate earnings quality, we find interesting evidence. Our investigation of discretionary accruals reveals that during the European sovereign debt crisis, exposed banks’ borrowers do not engage in less earnings management than other borrowers. However, we observe that exposed banks’ borrowers are more likely to report losses in a timely manner. Overall, our results provide new insight into the indirect consequences of the sovereign debt crisis on firms’ earnings quality.