The use of discretionary loan loss provisions by Islamic banks and conventional banks in the Middle East region

Abstract

Purpose -The purpose of this paper is to study earnings management practices of Islamic banks and conventional banks in the Middle East region. First, the authors examine factors that may influence Islamic banks managers' use of discretion in reporting loan loss provisions (LLP). Second, the authors investigate differences that may exist between Islamic banks and non-Islamic banks in terms of discretionary loan loss provisions (DLLP) used to manipulate accounting earnings. Design/methodology/approach -This empirical study uses an unbalanced panel data of 21 Islamic banks, 18 conventional banks with Islamic windows and 33 conventional banks, from seven Middle East countries during a period that ranges from 2000 to 2008. The authors use a two-stage approach in order to examine factors that may influence the use of discretion by Islamic banks' managers. Findings -The empirical results reveal that Islamic banks use DLLP for both earnings and capital management. External financing is also found to be a determinant of DLLP. Additional findings show no significant differences among Islamic banks, conventional banks with Islamic windows and conventional banks in using DLLP. These three groups of banks behave similarly in terms of discretion based on DLLP. Practical implications -The findings are potentially useful for regulators, auditors and investors. This study provides regulators with insights to strengthen their financial regulations in order to improve accounting quality. In addition, it helps auditors when considering the provisioning policies adopted by banks in order to detect specific manipulations of accounting earnings. The results may also help investors to focus on the impact of managerial discretion on accounting earnings for evaluation purposes. Originality/value -This study contributes to the literature on Islamic banking. On the one hand, it extends prior research by examining the discretionary component of LLP, instead of being restricted to total LLP. On the other hand, it compares the use of discretion among three groups of banks: full Islamic banks, conventional banks with Islamic windows and full conventional banks. SEF 31,1 106 1. Introduction A wide literature has addressed the issue of earnings management in the banking industry. It is shown that banks around the world are found to manage their earnings and banks' managers are motivated to minimize the earnings volatility over time. Current literature provides evidence that loan loss provisions (LLP) are used by banks as an instrument for long-term earnings management (Collins et al., 1995;Ismail and Be Lay, 2002;Anandarajan et al., 2005Anandarajan et al., , 2007Taktak et al., 2010a). Most existing studies have concentrated on conventional banks. However, little attention has been given to earnings management in Islamic banks in the Middle East region.Recent studies such as Zoubi and Al-Khazali (2007) and Taktak et al. (2010b) addressed the issue of the use of LLP in Islamic banks. Zoubi and Al-Khazali (2007) argue that Islamic banks use LLP to ...

Bank loan loss provisions research: A review of the empirical literature

“…This study concludes that there is an impact of the financial crisis in several European countries using fuzzy-set qualitative analysis (fsQCA) there are indications of reducing earnings management and capital management practices. Some research articles state that banks use LLP as a tool to carry out long-term income management (Anandarajan, Hasan, & Lozanovivas, 2003;Laeven & Majnoni, 2003;Taktak, Zouari., & Boudriga, 2010;Taktak, 2011;Othman & Mersni, 2014;Shawtari et al, 2015;Wijayanti & Diyanty, 2017;Curcio, Simone, & Gallo, 2017;Abu-serdaneh, 2018;Isa & Rashid, 2018;Ozili & Outa, 2018) On the other hand there is research which states that bank managers do not use LLP as a tool to practice earnings management (Ahmed, Takeda & Thomas, 1999;Leventis, Dimitropoulos, & Anandarajan, 2013;Adzis, Tripe, & Dunmore, 2016)…”

“…The decrease in LLP can affect the capital adequacy ratio and have an impact on decreasing income (Abu-serdaneh, 2018). Othman & Mersni, (2014) research that shows that banks use current income with the motivation to minimize income volatility over time.…”

“…There are several articles that focus on income smoothing and LLP in banking industry (Taktak, Zouari., & Boudriga, 2010;Taktak & Taktak, 2011;Leventis, Dimitropoulos, & Anandarajan, 2013;Beatty & Liao, 2014;Adzis, Tripe, & Dunmore, 2016;Cummings & Durrani, 2016;Wijayanti & Diyanty, 2017;Ozili & Outa, 2018;Pinto & Picoto, 2018;Isa & Rashid et al, 2018), another topic focus on signaling activities and LLP examine by (Sood, 2012;Othman & Mersni, 2014;Fitriana & Arfianto, 2015;Abuserdaneh, 2018;Ozili & Outa, 2018;Isa & Rashid, 2018).…”

How do Indian firms cope with a crisis? - Earnings management characteristics of CNX Nifty 100 companies

“…Gombola, Ho and Huang (2016) have also linked the recent literature in leverage and liquidity to earnings and capital management. Othman and Mersni (2014) provide an informative analysis using Loan Loss provisions (LLPs) in Middle eastern banks while Ozili (2018) links Discretionary LLPs to macroeconomic progress and investor protection.…”

“…In the presence of basic data on Loan Loss provisions and trading gains on securities the analysis shows the presence of earnings management in the financial firms (tested in only Banking firms) as being more sophisticated than that in the sample of Non-financial firms. Elleuch and Taktak (2015) decode earnings management in banks as regulations change while Ozili (2018) and Othman and Mersni (2014) trace the macroeconomic cycles and efficient and effective earnings management by banks using Discretionary LLPs.…”