Banks and income smoothing: an empirical analysis

Abstract

The income smoothing hypothesis is examined for large banks that reported their earnings over the period 1981–1991. It is analysed whether banks use loan-loss provisions to manipulate earnings. Results suggest that banks with close relationships between their loan-loss provisions and their earnings before loan-loss provisions but after taxes do tend to have smooth earnings. This conclusion is statistically significant within the 5% level. An examination of the influence of firm-specific conditions on the time-series behaviour of the provisions for loan losses reveals that the Tax Reform Act of 1986 does not have an impact on income smoothing. We find that banks with low growth, low book-to-asset ratio, high loans-to-deposit ratio, high debt-to-asset ratio, low market-to-book value ratio, low return on assets, high loan-loss provisions to gross loans ratio and low assets are likely to smooth their earnings. Our analysis indicates that the stock market perceives the income-smoothing behaviour of banks.