Earnings Quality and Bank Equity

Abstract

This doctoral thesis reports the results of three studies that address the implications of two bank characteristics - bank efficiency and bank earnings quality - for bank dividend policy and specified capital market outcomes. Chapter 1 introduces the thesis. The first study links the market reactions to dividend change announcements by banks to changes in bank efficiency score, our new measure of bank overinvestment problem, derived from a frontier analysis of bank input-output combinations. We find that improvement in bank overinvestment problem, defined as changes in bank efficiency, is significantly and positively associated with market reactions following dividend increases. However, consistent with the moderating role of bank regulation, we find no support for the role of changes in bank efficiency in market reactions to dividend decreases. The second study establishes a link between bank earnings quality and bank cost of equity capital. Using various earnings quality measures, the study finds that banks with better earnings quality experience lower cost of equity capital. Consistent with this primary finding, our results also support the idea that banks with higher earnings quality enjoy higher market valuation and higher price-earnings multiples compared to banks with lower earnings quality. Overall, our results suggest that markets can differentiate between “good” and “bad” earnings and seem to compensate banks with better earnings quality. The third study contributes to the literature by first developing a country-specific index of bank earnings quality. We further hypothesise that banks in countries characterised by high earnings quality pay more dividends than banks in countries with lower earnings quality. Our data give support to this hypothesis. Finally, using modified partial adjustment models that incorporate our index of earnings quality, we find that the dividend-earnings relation is stronger for banks operating in countries with high earnings quality than for banks operating in countries with low earnings quality.