The association between fair value measurements and banks' discretionary accounting choices

This study examines the association between fair value measurements and banks' discretionary loan loss provisions using regulatory financial data from 2009 to 2016 for a sample of U.S. public bank holding companies. I find that banks recognizing larger proportions of fair value assets and liabilities based on level 2 and level 3 inputs are associated with lower discretionary loan loss provisions. However, there is no significant association between level 1 fair value assets and liabilities and discretionary loan loss provisions. When pre-managed earnings are lower, banks with larger proportions of level 2 and level 3 fair value assets and liabilities report smaller discretionary loan loss provisions to inflate earnings. Banks reporting larger proportions of level 2 and level 3 fair value assets and liabilities are more likely to use discretionary loan loss provisions to beat earnings benchmarks and manage tier one capital ratios. Overall, the results support the proposition that fair value assets and liabilities based on level 2 and level 3 inputs are less transparent and are subject to more discretion regarding loan loss provisions.     

Loan Loss Provisions, Earnings Management and Capital Management under IFRS: The Case of EU Commercial Banks

Prior research has shown that loan loss provisions are primarily used as a tool for earnings management and capital management by listed banks. Effective 2005 all listed companies in the European Union (EU) are required to comply with International Financial Reporting Standards (IFRS). Adherence to IFRS, it is claimed, should enhance transparency of reporting practices relative to local General Accepted Accounting Principles (GAAP). The overall objective of this paper is to examine the impact of the implementation of IFRS on the use of loan loss provisions (LLPs) to manage earnings and capital. We use a sample of 91 EU listed commercial banks covering a period of 10 years (before and after implementation of IFRS). Since early adopters may have different incentives and motivations relative to those who adopt mandatorily, we dichotomize our sample into early and late adopters. Overall, we find that earnings management (using loan loss provisions) for both early and late adopters while significant over the estimation window is significantly reduced after implementation of IFRS. We also find that, for risky banks, earnings management behavior is more pronounced when compared to the less risky banks, but is significantly reduced in the post IFRS period. Capital management behavior by bank managers is not significant in both pre and post IFRS regimes. Overall, we conclude that the implementation of IFRS in the EU appears to have improved earnings quality by mitigating the tendency of bank managers of listed commercial banks to engage in earnings management using loan loss provisions.     

Capital and Earnings Management: Evidence from Alternative Banking Business Models

This paper examines whether institutional characteristics distinguishing Islamic from conventional banks lead to distinctive capital and earnings management behavior through the use of loan loss provisions. In our sample countries, the two banking sectors operate under different regulatory frameworks: conventional banks currently apply the “incurred” loan loss model until 2018 whereas Islamic banks mandatorily adopt an “expected” loan loss model. Our results provide significant evidence of capital and earnings management practices via loan loss provisions in conventional banks. This finding is more prominent for large and loss-generating banks. By contrast, Islamic banks tend not to use loan loss provisions in either capital or earnings management, irrespective of the bank's size, earnings profile, or the structure of their loan loss model. This difference may be attributed to the constrained business model of Islamic banking, strict governance, and ethical orientation.     

The procyclicality of loan loss provisions in Islamic banks

From a sample of Islamic banks around the world from 1997 to 2012, this paper examines whether loan loss provisioning in Islamic banks is procyclical. Our empirical findings highlight that loan loss provisioning in Islamic banks remains procyclical, although the ‘expected’ loan loss model (E-LLM) has been implemented for Islamic banks in several countries. A closer investigation further documents that Islamic banks also use loan loss provisions for discretionary managerial actions, especially related to capital management in which loan loss reserves and provisions are inflated when bank capitalization declines. Eventually, this paper highlights that higher capitalization can mitigate the procyclicality of loan loss provisions in Islamic banks. In other words, loan loss provisioning becomes countercyclical for Islamic banks with higher capitalization. This paper therefore casts doubts on the adoption of the E-LLM for Islamic banks to promote countercyclical effects, because the E-LLM may be influenced by managerial discretion, including opportunistic capital management using loan loss provisions that may undermine the importance of maintaining bank capitalization.     

The influence of accounting enforcement on earnings quality of banks: Implications of bank regulation and the global financial crisis

We study the effects of country-level accounting enforcement on earnings quality of banks and whether bank regulation substitutes or complements the effect of accounting enforcement on bank earnings quality. We also examine whether the influence of accounting enforcement on bank earnings quality changed after the global financial crisis. Using a sample of listed banks from 40 countries between 2001 and 2014, and abnormal loan loss provisions (ALLP) as our main proxy for earnings quality, we document a consistent and strong association between accounting enforcement and bank earnings quality. More specifically, an increase in accounting enforcement decreases the level of ALLP and decreases the propensity to manage earnings to avoid losses. Furthermore, we provide empirical evidence that bank regulation complements the effect of accounting enforcement on bank earnings quality. Finally, unlike in the pre-crisis period, we find a positive association between accounting enforcement and income-decreasing ALLP in the post-crisis period, which indicates that stronger accounting enforcement is associated with more conservative earnings and higher loan loss reserves. Overall, our results indicate that accounting enforcement reduces opportunistic earnings management.     

Use of loan loss provisions for capital, earnings management and signalling by Australian banks

This study examines whether and to what extent Australian banks use loan loss provisions (LLPs) for capital, earnings management and signalling. We examine if there were changes in the use of LLPs as a result of the implementation of banking regulations consistent with the Basel Accord of 1988, which made loan loss reserves no longer part of Tier I capital in the numerator of the capital adequacy ratio. We find some evidence to indicate that Australian banks use LLPs for capital management, but we find no evidence of a change in this behaviour after the implementation of the Basel Accord. Our results indicate that banks in Australia use LLPs to manage earnings. Furthermore, listed commercial banks engage more aggressively in earnings management using LLPs than unlisted commercial banks. We also find that earnings management behaviour is more pronounced in the post‐Basel period. Overall, we find a significant understating of LLPs in the post‐Basel period relative to the pre‐Basel period. This indicates that reported earnings might not reflect the true economic reality underlying those numbers. Finally, Australian banks do not appear to use LLPs for signalling future intentions of higher earnings to investors.     

Loan growth and riskiness of banks

We investigate whether loan growth affects the riskiness of individual banks in 16 major countries. Using Bankscope data from more than 16,000 individual banks during 1997–2007, we test three hypotheses on the relation between abnormal loan growth and asset risk, bank profitability, and bank solvency. We find that loan growth leads to an increase in loan loss provisions during the subsequent three years, to a decrease in relative interest income, and to lower capital ratios. Further analyses show that loan growth also has a negative impact on the risk-adjusted interest income. These results suggest that loan growth represents an important driver of the riskiness of banks.     

Information Content of Earnings and Earnings Components of Commercial Banks: Impact of SFAS No. 115

SFAS No. 115 modified classification of debt and equity securities held by firms and also modified the reporting format for unrealised gains/losses on security transactions (URGL). This study investigates whether implementation of SFAS No. 115 improved information content of earnings and earnings components of commercial banks. Improvement in the information content is measured by comparing the association between equity returns and earnings and earnings components of the post-adoption period of SFAS No. 115 with the pre-adoption period.The test results indicate that the association of equity returns with earnings components and aggregate earnings is significantly stronger in the post-adoption period compared to the pre-adoption period. The improvement is especially evident for the components of URGL and non-interest revenues. These results suggest that information provided by earnings components is considered more value relevant for investment decision after implementation of SFAS No. 115. Findings on non-interest revenues indicate that revenues from banking activities other than lending also play an important role in the commercial banks' profitability.     

Bank Portfolio Allocation: The Impact of Capital Requirements, Regulatory Monitoring, and Economic Conditions

This paper develops a structural, dynamic model of a banking firm to analyze how banks adjust their loan portfolios over time. In the model, banks experience capital shocks, face uncertain future loan demand, and incur costs based on their proximity to regulatory minimum capital requirements and the intensity of regulatory monitoring. Implications of the model then are estimated using panel data on large U.S. commercial banks operating continuously between December 1989 and December 1997. The estimated model is used to simulate the optimal bank response to (1) past and proposed changes in capital requirements, (2) changes in regulatory monitoring intensity, and (3) economic downturns. The simulation results are used to shed light on the decline in loan growth and the rise in bank capital ratios witnessed over a decade ago as well as the possible impact of the current proposed modification to capital requirements.     

Earnings versus capital ratios management: role of bank types and SFAS 114

We document in this paper that large banks use Loan Loss Provisions (LLP) more than small banks to manage reported earnings, but we find no significant difference in the use of LLP to manage capital ratios between large and small banks. Additionally, we document that banks with high risk asset portfolios use more LLP to manage reported earnings as well as capital ratios compared to the banks with low risk asset portfolios. Our findings also show that SFAS 114 has a moderating effect on the use of LLP to manage reported earnings, especially by large banks, but there is no conclusive evidence on the impact of SFAS 114 to manage capital ratios. Furthermore, the findings show that there has been significantly more earnings management during the 2007–2008 financial crisis compared to earlier periods.     

Discretionary Loan Loss Provisions and Systemic Risk in the Banking Industry

This study examines the relation between earnings management through discretionary loan loss provisions (LLPs) and systemic risk in the U. S. banking sector using a large sample of commercial banks from 1996 to 2009. We find that earnings management increases a bank's contribution to systemic crash risk and systemic distress risk, consistent with the notion that earnings management increases information opacity, facilitates bad news hoarding, co‐moves with macroeconomic conditions, and exhibits cross‐sectional correlation and herding in earnings management. However, the effect of earnings management through discretionary LLPs on systemic risk disappears during the crisis period, consistent with weakened earnings management in crisis times. We also find that the same effect strengthens with bank uncertainty and homogenous loans, and weakens in the post‐SOX period, and when banks are audited by Big 4 auditors.     

Bank earnings and regulatory capital management using available for sale securities

Based on a large sample of publicly listed and non-listed US commercial banks from 1996 to 2011, we find robust evidence consistent with banks using realized available for sale (AFS) securities gains and losses to smooth earnings and increase low regulatory capital. We also find that (i) banks with positive earnings smooth earnings, and banks with negative earnings generally take big baths; (ii) regulatory capital constrains big baths; (iii) banks with more negative earnings and more unrealized beginning-of-quarter losses (gains) take big baths (smooth earnings); and (iv) banks with low regulatory capital and more unrealized gains realize more gains. Also, banks with negative earnings take big baths (avoid or reduce the earnings loss) if their unrealized gains are insufficient (sufficient) to offset the negative earnings. Our inferences apply to listed and non-listed banks, which indicates that the earnings management incentives do not derive solely from public capital markets. Our findings reveal that the accounting for AFS securities gains and losses enables banks to manage regulatory capital and earnings in a variety of ways.     

Earnings and capital management and signaling: the use of loan-loss provisions by European banks

This paper investigates the relationship between loan-loss provisions (LLPs) and earnings management in the context of the capital adequacy of Euro Area (EA) banks versus non-EA credit institutions. This paper also examines whether LLPs signal managements’ expectations concerning future bank profits to investors. Additionally, this paper traces the role of bank regulations and creditor protection systems in explaining income smoothing. Evidence drawn from the 1996 to 2006 period indicates that LLPs do reflect changes in the expected quality of a bank's loan portfolio for both groups of banks, and that earnings management is an important determinant of LLPs for EA intermediaries, whereas non-EA credit institutions use LLPs to signal private information to outsiders. The paper also finds that higher protection of creditors’ rights significantly reduces the incentives to smooth earnings for EA banks. During the recent financial crisis, EA bank managers are much more concerned with their credit portfolio quality and do not use LLPs for discretionary purposes, whereas LLPs at non-EA banks are used to smooth income more than for the purposes of managing capital ratios or conveying private information about future performance to the market.     

预期信用损失模型对银行资本计提的结构性影响研究——基于50家上市商业银行的实证分析

预期信用损失模型是一项新的贷款损失准备计提方法,对其经济后果的评估非常重要.关于预期信用损失模型的实施对我国商业银行资本计提的具体影响,目前还缺乏深入系统的研究.本文结合我国50家上市商业银行的公开数据,从监管资本、会计损益和资本计提前瞻性的角度分析了预期信用损失模型对我国商业银行资本计提的影响.研究结果表明:总体影响上,商业银行的贷款损失准备计提金额显著增加,利润波动增强,对资本充足率带来一定冲击;从不同特征商业银行看,小型商业银行、使用权重法商业银行、城市商业银行和H股上市商业银行受到的影响更为严重;从资本计提的前瞻性看,贷款损失准备的前瞻性得到加强,顺周期性效应得到一定程度缓解,但并不能完全消除.     

THE ROLE OF LOAN LOSS PROVISIONS IN EARNINGS MANAGEMENT,CAPITAL MANAGEMENT,AND SIGNALING: THE SPANISH EXPERIENCE

While much research has been conducted in the United States on the use of loan loss provisions (LLPs) as a mechanism for managing earnings, managing capital, and as a tool for signaling future earnings strategies, there is a paucity of research in Europe. In this research, we replicate methodology used by Ahmed, Takeda and Thomas (1998) and examine the relative importance of key factors affecting the LLP decisions of Spanish depository institutions. Among others, we focus on the role of organizational structure. We specifically examine if and how LLPs are used prior to and after the implementation of capital adequacy regulations in the Spanish depository industry in 1992. Our results indicate that while LLPs were not used as a tool for managing capital after the new regulation came into effect, banks have now adopted a more aggressive earnings management strategy. This appears to be because the capital adequacy regulation of 1992 removed any capital constraint that hitherto acted as a disincentive to aggressive earnings management. Commercial banks appeared to adopt a more aggressive earnings management as well as capital management strategy than savings banks in the post regulatory era. Finally, we did not find evidence that LLPs were used as a signaling tool by Spanish banks to portray their intentions about future earnings.     

Managing specific accruals vs. structuring transactions: Evidence from banking industry

This study investigates earnings management through managing specific accruals vs. structuring transactions in the banking industry. This paper explores the circumstances under which banks manipulate loan loss provisions vs. circumstances that lead banks to structure loan sales and securitizations for the purpose of achieving earnings benchmarks. Empirical results show that banks manage earnings through loan loss provisions, before resorting to structuring transactions, to avoid small earnings decreases and or just meet or beat analysts' forecasts. The findings imply that structuring loan sales and securitizations is more likely to be used as a secondary instrument. In addition, I find that the earnings of banks with lower discretionary loan loss provisions and higher discretionary gains from loan sales and securitizations are priced more negatively, suggesting that investors impose incremental penalties on the joint use of loan loss provisions and gains from loan sales and securitization to meet or beat earnings benchmarks.     

Ability of accounting and audit quality variables to predict bank failure during the financial crisis

We examine the ability of selected accounting and audit quality variables measured in a period prior to the financial crisis (i.e., the four quarters of 2006), to predict banks that subsequently failed during the financial crisis. We employ two sets of samples from the US: a troubled banks sample that includes banks that failed in or after 2007 as well as banks classified as being troubled based on profitability, loan quality, and balance sheet position in 2007, and a full sample that includes all banks with available required data. Using the troubled banks sample, we identify six reliable predictors of bank failure: auditor type, auditor industry specialization, Tier 1 capital ratio, proportion of securitized loans, growth in loans, and loan mix. For the larger full sample of banks, we identify the following ten predictors of bank failure: auditor type, Tier 1 capital ratio, proportion of securitized loans, nonperforming loans, loan loss provisions, growth in commercial loans, growth in real estate loans, growth in overall loans, loan mix, and whether the bank is a public bank.     

Income smoothing among European systemic and non-systemic banks

There is scant research on the financial reporting behaviour of global systemically-important banks (G-SIBs) and non-global systemically-important banks (non-G-SIBs). We examine the link between financial reporting and financial system stability given the understanding that income smoothing is a stability mechanism for banks. We empirically examine whether the way G-SIBs use loan loss provisions (LLPs) to smooth income differ compared to non-G-SIBs and the incentive to do so. We examine 231 European banks and find that income smoothing is pronounced among G-SIBs in the post-crisis period and pronounced among non-G-SIBs in the pre-crisis period. Also, G-SIBs exhibit greater income smoothing when they: (i) have substantial non-performing loans, (ii) are more profitable and meet/exceed minimum regulatory capital ratios (iii) engage in forward-looking loan-loss provisioning and during recessionary periods. The implication of our findings is that capital regulation and abnormal economic fluctuations create incentives for systemic banks to use accounting numbers (loan loss provisions) to smooth income, which also align with the financial system stability objective of bank regulators. Our findings are useful to accounting standard setters in their evaluation of the role of reported accounting numbers for financial system stability, given the current regulatory environment in Europe which focuses on systemic banks.     

Economic policy uncertainty and bank earnings opacity

Using a sample of U.S. banks and an index for economic policy uncertainty developed by Baker et al. (2016), we investigate whether economic policy uncertainty is systematically related to bank earnings opacity. When economic policy is relatively uncertain, it is easier for bank managers to distort financial information, as unpredictable economic policy changes make assessing the existence and impact of hidden “adverse news” more difficult for investors and creditors. Economic policy uncertainty also increases the fluctuation in banks’ earnings and cash flows, thus providing additional incentives and opportunities for bank managers to engage in earnings management. Our results show that uncertainty in economic policy is positively related to earnings opacity, proxied by the magnitude of discretionary loan loss provisions and the likelihood of just meeting or beating the prior year’s earnings, and negatively related to the level of accounting conservatism (i.e., the timeliness of recognition of bad news relative to good news). Collectively, our results suggest that economic policy uncertainty leads to greater earnings opacity. We also find that the impact of economic policy uncertainty on financial reporting distortion is less pronounced for stronger banks (i.e., banks with high capital ratios).     

Loan loss accounting and procyclical bank lending: The role of direct regulatory actions

I provide evidence that loan loss accounting affects procyclical lending through its impact on regulatory actions. Regulators are more likely to place banks with inadequate loan loss allowances under enforcement actions that restrict lending, leading these banks to lend less during downturns. Further, I find that banks with lower regulatory ratings lend less when they have more timely provisions, consistent with research theorizing that timely provisions increase transparency and inhibit regulatory forbearance. This regulatory action mechanism expands on prior research that has focused on the effect of loan loss recognition on regulatory capital adequacy during economic downturns.