Joint Tests of Signaling and Income Smoothing Through Bank Loan Loss Provisions

Abstract

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.