Income Smoothing over the Business Cycle: Changes in Banks' Coordinated Management of Provisions for Loan Losses and Loan Charge-Offs from the Pre-1990 Bust to the 1990s Boom

Abstract

ABSTRACT:We provide evidence that banks smooth income by managing provisions for loan losses and loan charge-offs in a coordinated fashion that varies across the bust and boom phases of the business cycle and across homogeneous and heterogeneous loan types. In particular, during the 1990s boom, we predict and find that banks accelerated provisioning for loan losses and made this less obvious by accelerating loan charge-offs, especially for homogenous loans for which charge-offs are determined using number-of-days-past-due rules. We also provide evidence that the valuation implications of banks' provisions for loan losses and loan charge-offs vary across the phases of the business cycle and loan types reflecting the effect of these factors on banks' income smoothing. In particular, during the 1990s boom, we predict and find that charge-offs of homogenous loans have a positive association with current returns and future cash flows, because these charge-offs are recorded primarily by healthy banks with good future prospects reducing over-stated allowances for loan losses. We also predict and find that these charge-offs have a positive association with future returns that is explained by their positive association with future net income and recoveries. Our results are consistent with the market only partially appreciating healthy banks' overstatement of charge-offs of homogeneous loans based on number-of-days-past-due rules during the 1990s boom, because of the perceived nondiscretionary nature of these charge-offs.

Does Basel II affect the market valuation of discretionary loan loss provisions?

“…Thus, given an economic crisis, we should find that all banks engage in more income-increasing activities following the outbreak of the financial crisis in 2007. 2 Indeed, we find that Standardized banks recognize more income-increasing DLLPs and engage in more income smoothing after the adoption of Basel II, which is a normal response to the economic turmoil (as documented in Liu & Ryan 2006). Unlike Standardized banks, IRB banks need to comply with Basel II, which curbs their ability to smooth income through income-increasing DLLPs in the post-Basel II period.…”

“…Given our short-term window of analysis, we have a mild expectation to find support for the following hypothesis. According to Liu & Ryan (1995) and Liu & Ryan (2006), all else equal, banks prefer smoother earnings.…”

“…cash flows from the DLLPs of IRB banks (Wahlen 1994, Liu & Ryan 2006. We further perform F-tests to assess the relative change in the market valuation of DLLPs between the pre-and post-Basel II adoption periods.…”

How Does Internal Control Regulation Affect Financial Reporting?

“…Specifically, we examine the effect on small positive earnings changes. If increased persistence is driven by increased smoothing, which Liu and Ryan (2006) contend occurred during our sample period, then we would expect to find increases in this type of benchmark beating for affected banks. Alternatively, if FDICIA improves operating activity measurement, and banks were using loan-loss provision discretion to avoid missing benchmarks prior to the regulation, then we predict a decrease in benchmark beating for affected firms.…”

Macro and micro prudential regulatory failures between banks in the United Kingdom and Australia 2004‐2009

“…Data about non-performing loans are found in annual reports and are a useful source of information about loan default. (Liu & Ryan, 2006) Their results show that non-performing loans have a positive correlation with bank failures. Due to difficulty in obtaining data, the author has only managed to obtain information on non-performing loans in UK and Australian banks.…”