Discretionary Loan-Loss Provision Behavior in the US Banking Industry

Abstract

Earnings management can be either opportunistic, adding noise to reported earnings, or informative about a firm's underlying economic performance, adding valuable information to financial reports. This study examines earnings management in banks with differing levels of information asymmetry. Specifically, we compare earnings management between public and private banks by using discretionary loan-loss provisions (DLLPs) as proxies. Employing a large dataset of US public and private banks from 1986:Q1 to 2013:Q4, this study provides evidence of stronger earnings management behavior in public banks versus private banks. The evidence remains robust under a battery of sensitivity tests. Since incentives for earnings management are more relevant within a specific context, we identify the conditions that motivate different earnings management incentives, which allows us to better observe specific managerial motives. Greater DLLPs observed in public banks are utilized to send private information to investors, consistent with the signaling hypothesis. We also find evidence that capital requirements alter DLLPs, consistent with the capital management hypothesis. Banks with relatively low (high) earnings tend to decrease (increase) their earnings through manipulation of DLLPs, inconsistent with our income-smoothing hypothesis. The study extends to current debates on earnings management between public and private firms, and also provides a better understanding of the determinants of earnings management. About the Authors: Viet-Dung Tran is affiliated with the Center for Studies and Applied Research in Management (CERAG) and Université Grenoble Alpes. He pursues research on the capital structure of AbstractEarnings management can be either opportunistic, adding noise to reported earnings, or informative about a firm's underlying economic performance, adding valuable information to financial reports. This study examines earnings management in banks with differing levels of information asymmetry. Specifically, we compare earnings management between public and private banks by using discretionary loan-loss provisions (DLLPs) as proxies. Employing a large dataset of US public and private banks from 1986:Q1 to 2013:Q4, this study provides evidence of stronger earnings management behavior in public banks versus private banks. The evidence remains robust under a battery of sensitivity tests. Since incentives for earnings management are more relevant within a specific context, we identify the conditions that motivate different earnings management incentives, which allows us to better observe specific managerial motives. Greater DLLPs observed in public banks are utilized to send private information to investors, consistent with the signaling hypothesis. We also find evidence that capital requirements alter DLLPs, consistent with the capital management hypothesis. Banks with relatively low (high) earnings tend to decrease (increase) their earnings through manipulation of DLLPs, inconsistent with our income-smoothing hypothesis. The s...

Activity Strategies, Agency Problems, and Bank Risk

“…Excluding banks that only partially existed during the period studied mitigates the effects of merger and acquisition activities and bank defaults, though at the price of overrepresenting “successful” banks. This also attenuates the concern of poorly performing banks (Tran, Hassan, and Houston 2018b). The results remain robust.…”

How does listing status affect bank risk? The effects of crisis, market discipline and regulatory pressure on listed and unlisted BHCs

“…Recently, Tran, Hassan, and Houston (2018) also documents a greater earnings management of US public banks versus their private peers which is partially explained by the pressure of capital requirements. Since banks become more opaque when manipulating their reported numbers, it interferes with private governance and official regulation of banks (Jiang, Levine, and Lin (2016)), leading higher opportunities for expropriation, and higher insolvency risks (Fosu et al (2017).…”

“…Our study focuses on a single country, alleviating the endogeneity issue associated with crossborder research, since the decision to go public or private and the financial reporting quality could be jointly determined by country-and institutional-level characteristics such as securities regulations and disclosure rules (Kim andYi, 2006, Tran, Hassan, andHouston, 2018). Imposing these limitations makes our evidence stronger, cleaner, and more robust.…”

Discretionary Loan Loss Provision Behaviour and Banks’ Liquidity Creation

“…As mentioned above, the versatility and intent to use discretionary feature of the LLP by banks have been explored by many researchers. There are studies that looked at the behavioural pattern of usage of the provision during the crisis eras and normal business cycle (Laeven & Majnoni, 2003;El Sood, 2012;Agénor & Zilberman, 2015); relationship between pro-cyclical use of the LLP and uncertainty of the financial system as well as the systemic risk (Borio, Furfine, & Lowe, 2001;Wong, Fong, & Choi 2011); accommodating use of LLP and pro-cyclicality (Saurina, 2009;Perez, Salas-Fumas, & Saurina, 2008); the role that LLP plays in managing earnings, regulatory capital, signaling and tax (Lobo & Yang, 2001;Kanagaretnam, Lobo, & Yang, 2005;Anandarajan, Hasan, & McCarthy, 2007;Perez, Salas-Fumas, & Saurina, 2008;Peterson, 2015;2017a;2017b;Andries, Gallemore, & Jacob, 2017;Tran, Hassan, & Houston, 2018); LLP allowance discretion by bank managers under various accounting and regulatory country setups (Leventis, Dimitropoulos, & Anandarajan, 2011;Kilic, Lobo, Ranasinghe, & Sivaramakrishnan, 2012;Alali & Jaggi, 2011;Wezel, Chan Lau, & Columba, 2012;Ryan & Keeley, 2013;Hamadi, 2016;Marton & Runesson, 2017); LLP and bank operations (Tran & Ashraf, 2018;Tran, Hassan, & Houston, 2019); LLP and credit competition (Dou, Ryan, & Zou, 2016); relationship between LLP and characteristics of auditor (Kanagaretnam, Lim, & Lobo, 2010;Dahl, 2013); relationship between corporate governance, institutional control and discretionary LLP (Fonseca & Gonzàlez, 2008;…”