Earnings quality and performance in the banking industry: A profit frontier approach

The analysis of efficiency and productivity in banking has received a great deal of attention for almost three decades now. However, most of the existing literature to date has not explicitly accounted for risk when measuring efficiency. We propose an analysis of profit efficiency taking into account how the inclusion of a variety of bank risk measures might bias efficiency scores. Our measures of risk are partly inspired by the literature on earnings management and earnings quality taking into account that loan loss provisions, as a generally accepted proxy for risk,can be adjusted to manage earnings and regulatory capital. We also consider some variants of traditional models of profit efficiency where different regimes are stipulated so that financial institutions can be evaluated in different dimensions-i.e. prices, quantities, or prices and quantities simultaneously. We perform this analysis on the Spanish banking industry, whose institutions are deeply affected by the current international financial crisis, and where re-regulation is taking place. Our results can be explored in multiple dimensions but, in general, they indicate that the impact of earnings management on profit efficiency is of less magnitude than what might be a priori expected, and that the performance of savings banks has been generally worse than that of commercial banks. However, the former firms are adapting to the new regulatory scenario and catching up with commercial banks rapidly, especially in some dimensions of performance.