Managerial Incentives for Income Smoothing Through Bank Loan Loss Provisions

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, manage...

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Bibliographic Details
Published in:	Review of quantitative finance and accounting 2003-01, Vol.20 (1), p.63-80
Main Authors:	Kanagaretnam, Kiridaran, Lobo, Gerald J, Mathieu, Robert
Format:	Article
Language:	eng
Subjects:	Accounting Bank loans Bank management Banking industry Banks Borrowing Capital requirements Employment security Finance Financial performance Financial reporting Incentives Income Job security Loan losses Management Management accounting Multivariate analysis Provisions Regulation of financial institutions Regulatory agencies Studies
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Summary:	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. [PUBLICATION ABSTRACT]
ISSN:	0924-865X 1573-7179