Power Play: How Bank Market Power Shapes Earnings Management in European <scp>SMEs</scp>

ABSTRACT This study examines the effects of bank market power on borrowing firms' earnings management. Through the lens of banking relationships, we use uniquely matched data on a one‐to‐one banking relationship between 64,635 Small and Medium‐Sized Enterprises (SMEs) and 471 banks across 17 European countries between 2007 and 2015. We measure bank market power at a disaggregated level, and find an unfavourable effect of bank market power on SME earnings management where SMEs tend to engage in more earnings management when their primary bank possesses a greater level of market power. Such effects are more prominent for firms that are smaller in size, more illiquid, grow more slowly, and over the financial crisis period during which credit supply reduced and SMEs were less incentivised to manage earnings. Our findings contrast with recent empirical evidence from listed firms and bank market deregulation at an aggregated level in the US market. Our results shed new light on supporting evidence for the market power hypothesis.