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Government Guarantees and Banks' Income Smoothing

Prior studies find that banks engage in income smoothing to distort financial performance in ways that have implications for capital allocation and regulation. We examine whether banks' incentives to engage in this behavior are reduced by government guarantees, which mitigate concerns about financial stability during economic downturns. We exploit the increase in implicit guarantees following the Eurozone creation and the removal of explicit guarantees of the Landesbanken as two distinct but complementary settings, showing that increases (decreases) in government guarantees are associated with significant decreases (increases) in banks' income smoothing. Our findings suggest government guarantees significantly affect banks’ provisions and reported income.