Regulatory Capital and Earnings Management in Banks: The Case of Loan Sales and Securitizations

Abstract

In this paper, I investigate whether banks use loan sales and securitizations (loan transfers) to manage regulatory capital and earnings. My analysis suggests that banks use gains from loan transfers to influence both reported earnings and regulatory capital after controlling for other economic motivations. The gains can be attributed both to cherry-picking of loans whose market values exceed their book values and also to overvaluation of the retained interests that are carried at fair market value in the case of securitizations. In addition, the use of securitizations for financial statement management is positively associated with the degree of financial reporting discretion available to managers. Finally, regulatory capital considerations seem to play a significant role in the decision to transfer loans, while earnings management considerations are more important in the calculation of reported gains conditional on performing a transfer, particularly in the case of securitizations.