The Impact of SFAS 133 on Income Smoothing by Banks through Loan Loss Provisions

Abstract

We examine the impact of SFAS 133, Accounting for Derivative Instruments and Hedging Activities, on the reporting behavior of commercial banks and the informativeness of their financial statements. We argue that, because mandatory recognition of hedge ineffectiveness under SFAS 133 reduced banks' ability to smooth income through derivatives, banks that are more affected by SFAS 133 rely more on loan loss provisions to smooth income. We find evidence consistent with this argument. We also find that the increased reliance on loan loss provisions for smoothing income has impaired the informativeness of loan loss provisions for future loan defaults and bank stock returns. Data Availability: The data are available from public sources.

Bank Loan Loss Provisions Research: A Review

“…This is the capital management hypothesis. On the other hand, Kilic et al (2012) and Bonin and Kosak (2013) suggest an alternative view to the capital management hypothesis. They argue that, in the absence of minimum regulatory capital ratios, banks will view LLPs as a form of bank capital.…”

“…The literature that test the capital management hypothesis examine whether banks increase LLPs when they have insufficient equity capital to compensate for their low equity capital levels (Bonin & Kosak, 2013;Kilic et al, 2012) or whether banks influence LLP estimates to meet minimum regulatory capital requirements (Ahmed et al, 1999;Moyer, 1990). Notably, the work of Ahmed et al (1999) is core to this strand of literature.…”

“…Using dynamic panel estimation, they also observe that LLPs have a non-linear relationship with reported earnings. Kilic et al (2012) investigate whether the strict recognition and classification requirements of SFAS 133 that reduced US banks' ability to use derivatives to smooth earnings encouraged the affected banks to rely more on LLPs to smooth reported earnings rather than relying on derivatives. They find evidence that US banks use LLPs to smooth earnings when accounting disclosure regulation made it difficult to use derivatives to smooth bank earnings.…”

“…Since Wall and Koch (2000), emerging studies have examined several issues in the loan loss provisioning literature including: provisioning behaviour during fluctuating business cycles and crisis periods (Laeven & Majnoni, 2003;El Sood, 2012;Agenor and Zilberman, 2015), how procylical LLPs contribute to systemic risk and financial system instability (Borio, Furfine, & Lowe, 2001, pp. 1e57;Wong, Fong, & Choi, 2011), dynamic provisioning to mitigate LLP procyclicality (Saurina, 2009;Perez et al, 2011), the role of LLP in bank earnings management, regulatory capital management, signalling and tax management (Lobo & Yang, 2001;Kanagaretnam, Lobo, & Yang, 2005;Anandarajan, Hasan, & McCarthy, 2007;Perez, SalasFumas, & Saurina, 2008;Ozili, 2015Ozili, , 2017aAndries, Gallemore, & Jacob, 2017), bank manager's provisioning discretion under different accounting and regulatory regimes (Alali and Jaggi, 2011;Hamadi, Heinen, Linder, & Porumb, 2016;Kilic, Lobo, Ranasinghe, & Sivaramakrishnan, 2012;Leventis, Dimitropoulos, & Anandarajan, 2011;Marton & Runesson, 2017;Ryan & Keeley, 2013;Wezel, Lau, & Columba, 2012), provisioning and competition (Dou, Ryan, & Zou, 2016), provisioning under different auditor type, reputation and specialism (Dahl, 2013;Kanagaretnam, Lim, & Lobo, 2010;Ozili, 2017a), provisioning discretion under strong corporate governance mechanism and institutional controls (Fonseca and Gonzalez, 2008;Bouvatier, Lepetit, & Strobel, 2014;Curcio & Hasan, 2015) and provisioning behaviour in several country, regional and international contexts (Pain, 2003;…”

Loan Loss Provisions, Income Smooth, Signaling, Capital Management and Pro-Cyclicality. Empirical Evidence from Mozambique’s Commercial Banks

“…Also, recent banking literature provide evidence of using LLP to income smoothing such as Leventis et al (2012); El Sood (2012); Kilic et al (2013); Curcio and Hasan (2013); Bouvatier at al. (2014); Olson and Zoubi (2014); Cucinelli (2015); Bryce et al (2015); Adziz et al (2015); Fernando and Ekanayaka (2015); Skala (2015); Caporale et al (2015), Ozili (2015); Olszak et al (2016); Morris et al (2016) and Curcio et al (2017).…”