Purpose
Good earnings quality (EQ) provides reasonable assurance as to the reliability of future cash-flow generation capability of the borrowing firms and thereby mitigates the credit risk of the banks. Against the backdrop of the stressed-assets problem in public-sector banks in India, adversely impacting the public finance system, this paper aims to explore the role of EQ of the borrowers in obtaining bank credit and the ways to mitigate the problem.
Design/methodology/approach
Using a sample of listed 3,486 non-financial and non-government firms, the authors apply Jones (1991) model to estimate their EQ. Then, the authors conduct Hausman’s (1970) test and find the existence of a two-way relation between bank finance and EQ. The authors adopt a two-stage least-square regression model to test the nature of the association between the two after controlling for firm and industry-level characteristics.
Findings
The empirical results suggest that there exists a two-way negative association between EQ and bank finance implying that the Indian firms tend to report abnormal accruals to enhance tangibility for enjoying higher credit limits and easier access to bank finance. Also, the poor EQ is associated with earnings volatility, adversely impacting the credit quality. The findings are consistent.
Practical implications
The study highlights the role of EQ in mitigating credit risk and addressing adverse selection problems in granting credit by practicing bankers.
Originality/value
The findings of the study enrich the literature on EQ, capital structure, agency theory and public finance in several ways and have significant ethical and policy implications in bank-finance-led economies.
Credit Risk management in Banking Sector: A comparison of Non-Performing Assets of Public sector and Private sector Bank
