Managerial Incentives for Income Smoothing Through Bank Loan Loss Provisions |
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Authors: | Kanagaretnam Kiridaran Lobo Gerald J Mathieu Robert |
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Institution: | (1) Michael G. DeGroote School of Business, McMaster University, Hamilton, Ontario, Canada, L8S 4M4;(2) School of Management, Syracuse University, Syracuse, NY, 13244-2130, U.S.A.;(3) School of Business and Economics, Wilfrid Laurier University, Waterloo, Ontario, Canada, N2L 3C5 |
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Abstract: | We examine alternative underlying motives of bank managers in using loan loss provisions (LLP) to smooth reported income. Based on the analytical results of Fudenberg and Tirole (1995), we predict that for banks with good (poor) current performance and expected poor (good) future performance, managers will save income for (borrow income from) the future by reducing (increasing) current income through LLP. We also analyze three additional variables that could explain cross-sectional differences in the level of income smoothing. Our empirical analysis provides support for our predictions. The difference in LLP between the two groups of banks is positive as hypothesized, indicating that bank managers do save earnings through LLP in good times and borrow earnings using LLP in bad times. Similar results are obtained for analysis using discretionary LLP. When bank managers are saving earnings for the future, we provide evidence that the need to obtain external financing is an important additional variable in explaining cross-sectional differences in the extent of income smoothing. Furthermore, whether or not a bank is well capitalized is also weakly significant in explaining cross-sectional differences in income smoothing. |
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Keywords: | income smoothing loan loss provision job security |
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