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Effects of Climate Risk on Bank Earnings Management Activities
Fri, February 17, 4:45 to 5:45pm, TBAAbstract
The impacts of climate risk and reduced natural disaster insurance coverage on lending behaviors of banks motivates this study. This study examines whether natural disasters affect earnings management activities of banks that originate mortgages with high flood risk. The frequency of multi-billion dollar natural disasters, such as hurricanes, adversely impacts the strength and stability of our financial institutions. Wind and flood damage inflict untold cost on property owners, residents, insurance companies and the broader community in coastal areas. If banks engage in earnings management activities (i.e., manipulation) to overstate their financial strength in the face of disaster-related loan losses, our capital markets and national confidence in our financial institutions will be significantly eroded. This study argues that the channel through the sales of securitized loans might be limited for the affected banks, since these banks lower the sizes of their mortgages in flood risk areas to ensure that the loans satisfy the eligibility requirements of Fannie Mae and Freddie Mac. On the other hand, due to more strict scrutiny of securitization activities by the SEC after the 2008 global financial crisis and the implementation of SFAS 166/7, increasing earnings through securitization gains might be limited for all banks in general. This study documents that Affected banks are less (more) likely to engage in securitization earnings management (strategic offerings of available-for-sale securities for realized gains or losses) so as to increase earnings, compared to the control group following billion-dollar events, post SFAS166/7. This study intends to further explore the role of ESG ratings in the association between climate risk and earnings management activities. Findings have important implications on greenwashing policies.