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Keywords:

  • G01;
  • G11;
  • G21;
  • G28;
  • M40;
  • financial institutions;
  • earnings management;
  • crashes;
  • financial crisis

We show that a pattern of earnings management in bank financial statements has little bearing on downside risk during quiet periods, but seems to have a big impact during a financial crisis. Banks demonstrating more aggressive earnings management prior to 2007 exhibit substantially higher stock market risk once the financial crisis begins as measured by the incidence of large weekly stock price “crashes” as well as by the pattern of full-year returns. Stock price crashes also predict future deterioration in operating performance. Bank regulators may therefore interpret them as early warning signs of impending problems.