The impact of earnings management and the economic cycle on stress test results

The aim of this research is to determine whether the stress tests designed by the European Banking Authority have flaws that prevent them from providing an accurate picture of banks’ annual accounts. Based on the model defined by the European Banking Authority, ordinary least squares regression was used to develop two models: one for probability of default and one for loss given default. The analysis confirms the existence of earnings management. The analysis confirms the presence of earnings management during periods of growth. Accordingly, the way in which banks make their loan loss provisions differs significantly depending on the phase of the economic cycle. Earnings management exacerbates information asymmetries in the stock market and consequently distorts companies’ value and market capitalization. This leads to a lack of confidence and causes instability in the financial markets, which negatively affects the economy. This is the first study to examine the interrelationships between stress tests, the economic cycle, and earnings management.