Earnings Baths by Bank CEOs During Turnovers

Abstract

Reproduction permitted only if source is stated. Non-technical summaryThe chief executive officer (CEO) occupies an accentuated position in a firm's decisionmaking process. In this empirical study we investigate whether incoming CEOs in German banks engage in big bath accounting during their first year in charge. Taking such an earnings bath lowers the performance benchmark to be achieved in subsequent years. As a poor performance in the first year is often not yet attributed to the managerial skills of the incoming CEO, doing so does not entail any drawbacks with respect to his or her remuneration or reputation.Our findings from a sample of German savings banks over 1993-2012 are as follows.We document that incoming CEOs increase discretionary expenses during their first year in charge. Succeeding CEOs from outside the bank take a larger earnings bath than those from the inside, and incoming CEOs take a smaller earnings bath when the incumbent CEOs retire than when they leave for other reasons. These findings are insensitive to several modifications. Most importantly, the results hold even when we focus on banks that do not need to cure shortages in their existing stock of risk provisions, which may provide an alternative explanation for observable extraordinary amounts of discretionary expenses.This study is -to the best of our knowledge -the first to report on big bath accounting during CEO turnovers in the banking industry. It contributes to a better understanding of corporate governance in financial institutions and, for stakeholders, it helps to more correctly evaluate bank performance during turnover years. Nicht-technische Zusammenfassung University of Lueneburg AbstractThis study investigates the development of income-decreasing discretionary expenses surrounding CEO turnovers at banks. We expect incoming CEOs to take an earnings bath during the initial stage of their tenure. For a sample of German banks over the period 1993-2012, we document that (1) incoming CEOs increase discretionary expenses, i. e. engage in big bath accounting, during their first (partial) year in charge, (2) incoming CEOs from outside the bank take a larger earnings bath than insiders, and (3) incoming CEOs take a smaller earnings bath when the incumbent CEOs retire than when they leave for other reasons. Our findings are robust to several modifications. Most importantly, they also hold true when the incoming CEO's objective of rectifying shortages in the existing stock of risk provisions has been taken into account, which may provide an alternative explanation for observing extraordinary amounts of discretionary expenses in turnover years.