Banks’ funding structure and earnings quality

Abstract

Using a sample of U.S. public and private banks, we examine the implications of banks’ funding strategies for banks’ earnings quality. We find that the ratio of core deposits to total liabilities (CDL), our proxy for bank reliance on retail deposits over wholesale funds, is negatively and significantly associated with the magnitude of earnings management through discretionary loan loss provisions (DLLP). This finding is consistent with the arguments that retail deposits are relatively more stable and information-insensitive, reflect a more conservative business model, and attract more intensive monitoring from the Federal Deposit Insurance Corporation (FDIC) than wholesale funds. We find that the inverse relationship between retail funding and earnings management holds for both incomeincreasing and income-decreasing DLLP. Besides, reliance on retail funding decreases the likelihood of meeting-or-beating earnings benchmark, and the extent of income smoothing through loan loss provisions (LLP). In an additional analysis, we find that banks with higher CDL are exposed to lower asset deterioration risk, proxied by large non-performing loans and loan charge-offs during the financial crisis period 2007-2009. Collectively, our results indicate that the banks’ funding strategy that relies more on retail deposits as opposed to wholesale funds increases banks’ earnings quality. Valuation Insight: Bank value is affected by funding strategies. Increased reliance on funding from retail deposits as opposed to wholesale funds is found to increase a bank’s earnings quality, providing improved value-relevance of accounting earnings.