The Assurance of Government Guarantees: Ensuring Banking Stability and Customer Confidence

Fearful of choppy reports from a Silicon Valley bank in early March, many customers panicked and pulled out their money, causing the biggest bank failure since the 2007-2008 financial crisis. The problem – investors and customers have lost confidence in the bank, which proves that the perception of a bank’s reliability can greatly affect its success.

Investors tend to respond negatively to the volatility of companies’ performance. To alleviate investor concerns, when some banks get very high income, they sometimes delay reporting that amount until a later date when the income is down. In most cases, this practice is perfectly legal and is known in the industry as “income smoothing”.

A new study at the University of Missouri shows that the frequency with which banks participate in an income facility can be reduced with government guarantees — or a government-guaranteed subsidy in the event that a bank needs help ensuring that every customer has access to their money. For the study, Felipe Bastos Gurgel Silva, an assistant professor at the Robert J. Trulask College, analyzed the reports of several European banks during two historical instances when the amount of government support fluctuated.

“The banking sector will never function without government guarantees,” Silva said. “It helps banks prepare for extreme situations. And we found that as a result, banks feel less pressure to create an artificial perception of performance consistency in their public reporting.”

Silva and a team of researchers, including Manuela Dantas, assistant professor at California State University-Northridge, and Ken Merkley, professor at Indiana University, analyzed several reported numbers, including loan-loss provisions and advance earnings. Because government guarantees cannot be random as is often the case in biotechnology trials, the researchers analyzed two cases where government guarantees changed due to “external” factors not related to the individual banking sectors of their study. Specifically, the authors analyzed the increase in implicit government guarantees resulting from the creation of the eurozone and the elimination of explicit government guarantees given to Landesbanken, a group of large state-owned banks in Germany.

The creation of the eurozone in 1999 occurred for geopolitical reasons. However, the creation of a monetary union and the European Central Bank as lender of last resort increased tacit government guarantees to banks headquartered in the first countries that formed the eurozone. Conversely, express guarantees at Landesbanken were revoked in 2005 because other banks in Germany complained that such guarantees violated the terms of the EU Treaty.

“While our study of the creation of the eurozone does not prove a causal relationship, we show that the findings can be applied to many banks, not just the ones studied,” he said. And while the results for Landesbanken may not be applicable to other banks, we were able to find a causal relationship between government guarantees and income adjustment. Together, the fact that we are studying two complementary settings and that the results between the two are directionally consistent gives us a nice sense of how this affects These guarantees are on banks all over the world.”

While income smoothing adds to the overall amount of public reporting manipulation, Silva said there are pros and cons about this trend. He noted that if the reports are generally smoother, it boosts the overall amount of investors in the market, which could have a positive impact on the economy. However, he said previous research also shows that it may be beneficial to limit the total amount of income facilitation that occurs once to help reduce manipulation overall.

“There is previous research, done by people here at the University of Missouri, that shows that accounting manipulation can be an indicator of an upcoming recession,” Silva said. “Income smoothing is a form of accounting manipulation. Although it is not necessarily done with the intent to manipulate investors’ perceptions, many would argue that it is still a form of distortion.”