Do Banks Really Sell Securities to Smooth Earnings?

Abstract

This study re-examines the ways that profitable banks manage earnings through the gain and loss selling of available-for-sale securities. We find that what the prior literature calls earnings smoothing is more accurately characterized as the boosting of low earnings; banks boost low earnings via gain selling but do not meaningfully reduce high earnings via loss selling or abnormally low gain selling. Although the earnings boosting behavior represents a statistical tendency over a wide sample period, the behavior is relatively uncommon even among low-earnings banks, except in the three years immediately following the financial crisis of 2008-2009, facilitated by the Federal Reserve’s crisis-era bond buying program. Previously unavailable data on gross gains and losses reveals that the portion of the unrealized gain positions that banks realize each quarter is about three times the portion of the unrealized loss positions realized, on average. When they do sell loss positions, banks tend to completely erase the impact on earnings by selling additional gain positions roughly dollar-for-dollar. Overall, results suggest that when accounting standards insulate earnings from unrealized changes in security fair values, the primary form of material earnings management that occurs among profitable banks is occasional gain-selling to boost low earnings.