Income smoothing behavior of U.S. banks under revised international capital requirements

The use of the loan-loss provision to smooth reported income by large bank holding companies is a much-investigated practice. To the extent that the variability of net income is a measure of risk, income smoothing may reduce the perceived riskiness of the bank and thus increase stock value. Managers may have added incentive to smooth income in response to the structure of their compensation package. The Basel Accord of 1988 phased in new definitions of regulatory capital for banks. These changes have increased the incentives for income smoothing. Most previous studies on income smoothing and loan-loss reserves predate the implementation of the Basel Accord. Others use data that include the transition period. This study revisits the subject, using only post-Accord data. Results of this study are compared with previous results. The evidence confirms the continued existence of income smoothing and supports the proposition that banks have become more aggressive in using loan-loss reserves as a tool for income smoothing.