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Financial Interlocks and Earnings Management: Evidence from Italy

This paper examines financial interlocks between banks and industrial companies, and its relationship to earnings quality and the cost of debt. This issue is especially pertinent given the inherent conflict of interest present between banks and industrial firms, and their poorly understood inter-relationships. By examining a sample of Italian firms over the period 2001-2004, we document that the incidence of bankers on the board of industrial firms is negatively related to earnings management by the relevant industrial firm, suggesting that bankers perform a monitoring/control role that constrains opportunistic behaviour on behalf of management. On the other hand, the incidence of industrial executives on the boards of banks is positively related to earnings management by the industrial firm. This suggests that industrial firm executives who hold a board position in a bank, effectively capture the monitoring process. Additional analysis reveals that bankers also play an opportunistic role as well, protecting their investments when earnings of industrial firms fall, and through charging higher interest rates. Our results are robust to a large number of covariates and alternative statistical specifications including firm fixed effects, three stage least-squares, and OLS. A clear recommendation stemming from this study is that monitoring and lending should be kept separate, in line with the regulatory/litigation environment found in the USA.