Income smoothing through loan loss provisions in Asia–Pacific commercial banks: the role of managerial ability

Loan loss provisions and income smoothing – Do shareholders matter?

Purpose This study examines the effect of concentrated government ownership on the value relevance of the discretionary and non-discretionary components of loan loss provisions (LLP). While extant research has explored ownership characteristics in relation to income smoothing and the proportion of discretionary LLP, no study has investigated whether investors assign different values to LLP reported by firms with concentrated ownership characteristics. Design/methodology/approach The study employs a firm-fixed effects panel regression approach to analyze income smoothing behavior and value relevance for banks, conditional on government ownership. The study incorporates various robustness checks, such as alternative LLP specifications, market-adjusted returns and alternate deflators, to validate the robustness of the results. Findings The findings show that banks with controlling government ownership use LLP to smoothen their income and their use of LLP for income smoothing differs from that of private banks. Additionally, controlling government ownership negatively influences the value relevance of LLP’s discretionary component. Our findings suggest that investors do not perceive the discretionary LLP as “good news” for all banks. Originality/value To the best of our knowledge, this study is the first unitary analysis of the relationship between concentrated government ownership and the value relevance of LLP components. The study also contributes to the existing literature by offering new insights into the role of concentrated government ownership in earnings management.

This article investigates the relationship between discretionary loan loss provisions and bank intangibles among African banks. Prior studies have focused on how intangible assets affect firms’ profitability and valuation decisions with almost no focus on the role of loan loss provisions. We investigate whether banks increase (decrease) loan loss provisions in response to risks associated with investment in intangible assets. We find that discretionary loan loss provisions are inversely associated with bank intangible assets and change in intangible assets, but the inverse association is weakened in environments with strong investor protection. We observe that income smoothing is reduced among banks that have large intangible asset investment. Moreover, income smoothing is pronounced among banks that have few intangible asset investments but this behaviour is reduced for banks in environments with strong minority shareholders right protection.

This article investigates the relationship between discretionary loan loss provisions and bank intangibles among African banks. Prior studies have focused on how intangible assets affect firms’ profitability and valuation decisions with almost no focus on the role of loan loss provisions. We investigate whether banks increase (decrease) loan loss provisions in response to risks associated with investment in intangible assets. We find that discretionary loan loss provisions are inversely associated with bank intangible assets and change in intangible assets, but the inverse association is weakened in environments with strong investor protection. We observe that income smoothing is reduced among banks that have large intangible asset investment. Moreover, income smoothing is pronounced among banks that have few intangible asset investments but this behaviour is reduced for banks in environments with strong minority shareholders right protection.

PurposeThe purpose of this paper is to examine the determinants of the use of loan loss provisions (LLPs) to smooth income by banks in South Africa. More specifically, the authors examine the influence of ownership, IFRS disclosure rules and economic fluctuation on the income smoothing behaviour of South African banks while controlling for the traditional determinants of bank income smoothing via LLPs.Design/methodology/approachThe study employs fixed effect regression methodology to estimate the determinants of discretionary LLPs.FindingsThe authors find that South African banks do not use LLPs to smooth income when they are: under-capitalised, have large non-performing loans and have a moderate ownership concentration. On the other hand, income smoothing is pronounced when South African banks are rather more profitable during economic boom periods, well-capitalised during boom periods and is pronounced among banks that adopt IFRS and among banks with a Big 4 auditor. The authors also find that banks use LLPs for capital management purposes, and bank provisioning is procyclical with economic fluctuations.Practical implicationsBank supervisors in South Africa should monitor the bank provisioning practices in South Africa closely to ensure that LLPs are not used as a substitute for bank capital. Banks in South Africa should not use sufficient provisioning as a substitute for sufficient bank capital. Second, the evidence for procyclical bank provisioning shows that provisioning by South African banks reinforce the current state of the economy and might compel bank supervisors in South Africa to consider the adoption of a dynamic provisioning system that is already adopted by bank supervisors in Spain, Peru, Uruguay, Colombia and Bolivia.Originality/valueBank income smoothing is an important issue because it has implications for banking stability and accounting transparency. There are few studies on bank income smoothing for emerging economies particularly in Africa where there are substantial differences in ownership and accounting rules. This is the first South African study to examine the influence of disclosure rules, ownership and economic cycle fluctuations on bank income smoothing behaviour via LLPs.

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.

This paper analyses income smoothing behavior and procyclical effect of loan loss provisions in Islamic bank. The model includes the use of loan loss provisions for discretionary and non-discretionary purposes in Islamic banks and relates it to the ways of Islamic banks disburse loans. The empirical results show that Islamic banks use loan loss provisions for non-discretionary purposes, while well-capitalized banks and banks focusing on lending activities may use loan loss provisions for income smoothing to a lesser extent. Moreover, it is documented that higher non-discretionary component of loan loss provisions results in a decline in loan growth and hence, non-discretionary provisions are procyclical. In contrast, the discretionary component of loan loss provisions does not exhibit any significant impact on loan growth. Finally, the findings show that the negative link between non-discretionary provisions and loan growth does not hold for well-capitalized banks, and banks focusing on lending activities. This paper, therefore, highlights that higher capitalization and higher loan asset portfolios tend to neutralize the procyclical impact of non-discretionary provisions through their income smoothing behaviour. In this regard, the provisioning system is particularly recommended for less-capitalized banks and banks which do not focus on lending activities since they do not conduct income smoothing strategies.

The violation of regulatory targets is potentially costly for banks. To the extent that managers have discretion in setting loan loss provisions, they have strong incentives to use provisioning to manage regulatory capital and thereby reduce the costs of violating regulatory minimum targets. Like other types of businesses, banks also have income-smoothing incentives to manage loan loss provisions. Using a sample of 878 US bank holding companies over the period 2001-2009, I find strong evidence of both regulatory capital management and income smoothing behavior. I also test the regulators’ claim that the current accounting rules for loan loss provisions reinforce procylicality in regulatory capital, and that being in a recessionary period accentuates the association between loan loss provisions and tier 1 capital, consistent with the inherent procyclicality in current rules of loan loss provisioning.

This paper investigates how banks with different organizational cultures (defined as either control-dominant, collaborate-dominant, compete-dominant, create-dominant) manage their loan loss provisions (LLPs) in response to intensified industry competition. For identification, we utilize the change in state-level competition that followed the passage of the US Interstate Banking and Branching Efficiency Act (IBBEA) of 1994 as a quasi-natural experiment. We find that banks with a collaborate-dominant organizational culture are less likely to exercise discretion over LLPs. In contrast, banks with compete- and create-dominant organizational cultures are more likely to utilize discretionary LLPs when competition increases. Moreover, banks use discretionary LLPs to smooth income and signal private information to outsiders. Banks with collaborate-dominant organizational cultures exhibit less income smoothing. Counterparts with a create-dominant organizational culture use discretionary LLPs to signal information to outside stakeholders. Finally, banks with a create-dominant organizational culture are more likely to be subject to formal regulatory enforcement actions.

Loan loss provisioning and income smoothing in US banks pre and post the financial crisis

This study investigates the implications of bank managers' discretion over their loan loss provision. It empirically assesses whether discretionary loan loss provision contains both signaling and income smoothing components. To do so, the study identifies different environments in which either signaling or income smoothing or both motivations exist. The results indicate that relative undervaluation plays a critical role in motivating bank managers to use discretionary loan loss provision to signal their private information about future bank performance. The analysis also demonstrates that the level of current performance relative to the industry median is a key determinant of managers' decisions to smooth income.

text Using a single stage regression that models the non-discretionary part of loan loss provisions, we establish whether Ethiopian banks use loan loss provisions to smooth their income in a country with no foreign banks and high dominance of state ownership. Existing literature suggests that banks use loan loss provisions as a tool for income smoothing. Results support bank income smoothing via loan loss provisions and need of external fund have significant positive influence on loan loss provisioning towards income smoothing practice of Ethiopian banks in anticipation to attract external funds. Keywords: Banks, Ethiopia, IFRS, Income Smoothing, Loan Loss Provisions. DOI : 10.7176/EJBM/11-16-06 Publication date :June 30 th 2019

This paper is the first to examine whether the loan loss provisioning behavior of Islamic banks is procyclical. From a dynamic panel data methodology, the empirical results show that loan loss provisioning in Islamic banks is indeed procyclical, as higher economic growth leads to a decline in loan loss provisions. A closer investigation is also conducted to examine whether capital management, income smoothing, or signaling behavior can alter the procyclicality of loan loss provisions. Specifically, our results document that only capital management behavior can overcome the procyclicality of loan loss provisions. This paper therefore advocates the importance of strengthening discretionary behavior in Islamic banks in terms of capital management using loan loss provisions, particularly during economic boom.

Since the late 1970s’ reform and opening-up, China’s economy has achieved remarkable success, maintaining an average annual GDP growth of 9.7% from 1978 to 2006. In 2007, China achieved a GDP of 3.38 trillion USD, surpassing Germany to become the world’s third-largest economy, and by the second quarter of 2010, it had become the second-largest economy globally. These developments have attracted international investors’ attention to Chinese equities. However, China’s poor reputation for corporate governance may deter investors, despite their positive outlook on China’s economy. Corporate managers in China are known to engage in income smoothing, taking actions to dampen fluctuations in their firms’ publicly reported net income. In 2004, the OECD proposed that a strong disclosure regime promoting real transparency can help attract capital and maintain confidence in the capital market, with income smoothing being a key concern for both institutional and individual investors. This study investigates how auditor industry specialization (AIS) affects income smoothing behavior in Chinese listed companies. Using a sample of 27,208 firm-year observations from 2006 to 2018 collected from the Taiwan Economic Journal Database, the results indicate that AIS is negatively related to managers’ income smoothing behavior, underscoring the importance of industry expertise in mitigating such practices. Additionally, an independent t-test highlights the difference between Big Four and non-Big Four auditors in influencing client companies’ income smoothing behaviors. The study further demonstrates the significant moderating effect of Big Four auditors on the relationship between accounting firms with top industry expertise and client companies’ income smoothing, reflecting the unique characteristics of the Chinese market. This study verifies the suppressive effect of AIS on firms’ income smoothing and indirectly suggests that governments (or the Chinese Institute of Certified Public Accountants, CICPA) should regularly disclose accounting firms/auditors with industry expertise publicly. This regime can help global investors make informed investment decisions.

So far the earnings management literature has failed to establish the impact of taxes on the Loan Loss Provisions (LLPs) of financial institutions. We extend the discretionary LLP literature to a less studied area regarding the role of taxes in determining the behaviour of LLPs in a sample of 300 small banks in the period 1990?2004. Due to tax provisions that allow small banks to use LLPs, we find support for the hypothesis that taxes affect banks' discretionary LLPs. This finding is contrary to the findings of the few studies on this subject (Beatty et al., 1995; Scholes et al., 1990) that, using large banks, find little or no linkage between taxes and LLPs. We find that banks that were likely to pay the Alternative Minimum Tax (AMT) tended to lower their LLP. In addition, low Marginal Tax Rate (MTR) banks tend to have greater LLP than high MTR banks. Although the results may not be generalisable to the general population of banks and because LLPs are a large proportion of banks' income, these findings are important for bank regulators and analysts who may want to analyse LLP drivers.