Bank provision reversals and income smoothing: A case study

Incentives for banks to achieve income targets have previously been identified as a strong motivation for income smoothing (IS). Extant literature captures bank IS indirectly via discretionary provision estimations. In turn, our study directly locates IS through loan loss provision reversals. Drawing from bounded rationality perspectives, we investigate a systemic European Bank from January 2006 to September 2017, with 15,931 unique loan portfolio-quarter observations, employing a frequency and machine learning analysis. Our empirical investigation reveals both the main incentives underlying provision reversals recognition and the reported income consequences of such reversals, in times of recession. In particular, we find that provision reversals are principally used to avoid negative reported income (i.e., net losses). There is also some evidence that provision reversals are used to avoid income decline compared to the previous quarter. Finally, we show an asymmetric pattern of provision reversals over time with an emphasis on the early recession years. Our study contributes to the efforts of policy makers (both banking and accounting regulators) to reduce opportunistic, income-increasing actions by bank executives in difficult times.