The mediating effect of bank risk on the relationship between diversification strategies and discretionary loan loss provisions

Purpose

This study aims to investigate the effect of income and asset diversification on earnings management using discretionary loan loss provisions (LLP) in banks, and the role of risk level in mediating this effect.

Design/methodology/approach

A sample of banks operating in Middle East and North Africa countries was used to test the mediation model of Baron and Kenny (1986) with different measures of diversification and risk.

Findings

The results show that bank income and asset diversification have unique and combined effects on earnings management. The results also support the idea that a risk-mediating effect contributes to explaining this relationship among banks. Specifically, bank diversification strategies positively affect LLP-based earnings management by increasing bank risk. This result is relevant for conventional banks. However, only a direct and positive effect of diversification strategies on LLP-based earnings management can be observed in Islamic banks, and the indirect effect is not supported.

Originality/value

This study extends previous research by examining the unique and combined effects of income and asset diversification strategies on earnings management in the banking sector. Specifically, it provides new evidence that diversification strategies increase LLP-based earnings management, both directly and indirectly, through bank risk.