Literature Review on Banks Behavior with Respect to Loan Loss Provisions – Term Paper

Utilization of loan loss provisions in order to manipulate reporting earnings has been significantly discussed in numerous studies especially in developed countries. There are a number of reasons offered by researchers inclusive of contracts motivation, capital market incentives as well as regulation motivation (Skala, 2015). Bank managers utilize discretion in regards to loan allowances with an intention of managing earnings. The main argument is that credit quality of loan portfolios and a charge to earnings cannot be entirely determined by the objective criteria (W.D.I. & E.M.N.N, 2015). The security regulators and various banks identify that the loan loss provisions does not match the exact losses and is inclusive of margin for imprecision. A number of financial institutions in Europe as well as the United States have exploited this margin. Initially the LLPs were used in capital management, for signaling future expectations in the stock market and earnings management. In addition, the LLPs were used to manage risks, earnings volatility and to predict future changes in the earnings. Given that certain changes have been noticed in earnings and capital management, this literature review will establish the banks behavior in regards to loan loss provisions, smoothing income and managing regulatory capital.

Loan Loss Provisions and Smoothing Income

Effective earnings management is viewed as a indication of high quality investors since it offers useful information regarding equity valuation (An, Li, & Yu, 2016). In addition, it shows the stability of the institutions income sources. Smoothing of earnings level can be sustained through the management of accruals. LLPs is one of the most effective tool of managing earnings in banking institutions covering losses in the lending business. If the banks earnings are curiously high, they can use the discretionary reducing loan loss provisions and if they are low, LLPs can be understated in order to offset the operational losses  (An, Li, & Yu, 2016). Various research studies show that LLPs can be effective in managing earnings in the banks. According to the capital management hypothesis,  higher provisioning in cases when the capital is low show that LLPs prevent potential losses  (Frankel, Johnson, & Nelson, 2002). Other studies show that there is no relationship between loan loss provisioning and bank’s capitalization. This concurs with the pecking order theory ,which indicate that capital is expensive to be raised in the security markets frequently. In banks, LLPs are established for withstanding unexpected and expected losses because the provisions prevent expected losses and capital reserves prevent unexpected losses via RWAs (Hsieh & Wu, 2012). Therefore, when the relationship between change in RWAs and LLPs is negative, the bank managers generate higher loan provisions at the time when the risks weight decline. This confirms the capital management theory in different aspects (Mamatzakis, 2012).

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Another aspect in the management of earnings is its volatility. According to a survey conducted on non-financial institutions, 97% of the fund managers preferred the smooth earnings strategy. A number of studies have examined the importance of accruals in making sure that there is smoothness of the earnings in non-financial institutions. In regards to the banking institutions, researchers examine the volatility of equity depending on market reaction (Mamatzakis, 2012). Theoretically, it is expected that banks having stable profiles have smooth income because of reduction of uncertainty as well as easiness in prediction. In the process of making decisions, one of the important components is dividends through which the bank managers are willing to raise external funds, lay off employees and sell the assets (Hsieh & Wu, 2012). Managers in non-financial organizations manage the earnings using accruals if the expected payout of the dividends is below their target. However, in financial institutions such as banks, managers manage the earnings using downward strategy if the expected dividends are more than the current earnings. This is in line with the big path theory, which suggests that institutions reduce earnings through accruals in the current period.

 In reference to the non-public supervisory data from 85 banks in Netherlands from 1998 to 2012 where risk weighted assets and part of discretionary earnings was adjusted before LLPs, using multivariate analyses, a number of behaviors were identified. It was found that banks generate higher LLPs  if there were high discretionary earnings (Skala, 2015). On the other hand, they used lower LLPs in cases when there was an increase in discretionary risk weighted assets in these organizations. In addition, banks smoothed the earnings volatility via the loan loss provisioning. Dividend paying banks with more earnings than expected dividends increased discretionary LLPs. This was different from the behavior in non-financial institutions where it was found that they managed their earnings upward if they were unable to pay the dividends.

The results from a study conducted on 25 United States banks in a 20 year period from 1990 to 2010 showed that 98% of the managers used the LLPs  in managing their earnings to communicate private information regarding about their future expectations. IASB used principle-based standards and eliminated alternative accounting treatments to facilitate rigorous enforcements. Evidence show that  minimizing opportunity discretion in the banking sector has been able to increase the quality of earnings. In regards to the European Union, adoption of IFRS resulted to positive market reaction. The investors in the stock market view that using IFRS improves the quality of earnings when there are reduced discretion in the management (W.D.I. & E.M.N.N, 2015). Banks, which face higher levels of solvency risks, have an incentive of managing earnings with an intention of avoiding costs which are related to regulatory interventions. There is evidence of vulnerable banks of using excessive window dressing of profits as a strategy of adjusting LLPs (Mamatzakis, 2012). There is a close relationship between banks, which engage in excessive management of earnings and poor financial health. As a result, there are chances of banks facing insolvency to use LLPs in order to manipulate the accounting numbers reported at the end of the year.

In addition, the incentive to adjust capital adequacy ratio results from violation of the ratio that incurs regulatory costs  (Frankel, Johnson, & Nelson, 2002). Some research studies show negative relationship between capital ratios and LLPs  proving the subsistence of capital management behavior. However, in other studies there is no existence of capital management behavior. After the execution of Basel Accord I, the results showed that there was no evidence of Spanish and Australian banks in using LLPs because of the restrictions in the accord. However, there is motivation of banks which face high costs to apply capital management because of violation of capital requirements.

Before IFRS was adopted in the European Union, the banks used the general guidance in regards to loan loss provisioning. They depended on specific supervisory guidelines and accounting regulations in order to assess the provisional levels (Leventis, Dimitropoulos, & Anandarajan, 2010). Tax deductibility in loan losses offered an incentive of banks to set aside enough provisions in reference to tax acceptable levels and loan loss provisions to retain capital adequacy from the benefits associated with tax reductions. Based on the requirements of the Basel Committee, it is important for banks to utilize accounting principles which reflect prudency as well as conservative valuation of the loan loss provision decisions. The banks in Europe use the fourth directive under the accounting of accruals regardless of the cash flow timing. Accruals might be used significantly based on numerous factors in different European banks. Banks, which operate under the IFRS, are required to evaluate the general and specific allowances (Leventis, Dimitropoulos, & Anandarajan, 2010).