Academic journal article The International Journal of Business and Finance Research

Income Smoothing Practices of Us Banks around the 2008 Financial Crisis

Academic journal article The International Journal of Business and Finance Research

Income Smoothing Practices of Us Banks around the 2008 Financial Crisis

Article excerpt

ABSTRACT

The financial crisis of 2008 had a profound effect on the US banking industry, causing financial distress and the failure of a large number of banks. In this paper, we investigate whether or not banking institutions smoothed their reported earnings upward through the utilization of loan loss provisions during the financially challenging times of the Great Recession. Using a large dataset of commercial banks and thrifts, our empirical results provide support for the income smoothing hypothesis that banking institutions underestimated their provision for loan losses in order to offset their declining earnings in the period after the financial crisis.

JEL: G21, M41

KEYWORDS: Financial Crisis, Income Smoothing, Provision for Loan Losses, Commercial Banks, Thrifts

INTRODUCTION

Many consider the financial crisis of 2008 the worst economic downturn since the Great Depression of the 1930s. The financial crisis, which originated in the US financial sector, quickly spread to the global financial markets and economy. In the United States, the crisis had a severe impact on the workings of the banking system leading to financial distress and the failure of a large number of banking institutions. Given the critical role the banking sector plays in the nation's economy, the effects of the sector's declining position were felt in all aspects of the economic system. Statement of Financial Accounting Standards (SFAS) No. 5 (FASB 1975), Accounting for Contingencies, establishes the general financial accounting standards for the recognition of loan losses. SFAS No. 5 requires that creditors record an expense (called provision for loan losses) for an estimated loan loss if it is probable that a loan is impaired and its amount can be reasonably estimated. SFAS No. 114 (FASB 1993), Accounting by Creditors for Impairment of a Loan, provides additional and more detailed guidance on loan loss provisioning. Provision for loan losses is a large non-cash expense, and therefore has a significant downward effect on an institution's net income. Ahmed et al. (1999) report that the median ratio of provision for loan losses to earnings before provisions and taxes is 19% in their sample (in our sample, the median ratio is 14.67%). Banks record loan loss provisions in order to maintain a certain balance in their allowance for loan losses, the corresponding contra-asset account used to reserve for estimated loan losses during a given period (throughout this paper, the terms "bank" and "banking institution" refer to commercial banks, savings and loan associations, and savings banks [the latter two are also called "thrifts"] which accept deposits and make loans).

Under generally accepted accounting principles (GAAP), bank managers are allowed considerable subjective judgment in their loan loss provisioning. According to Wall and Koch (2000, p. 2), "although investors and regulators may prefer an accounting philosophy tailored to their needs, ultimately a bank's reported loan-loss allowance is largely under its managers' control, and managers are likely to use any available discretion to attain their own goals". The flexibility employed by banks in determining provisions for loan losses enables them to manage their accounting earnings in an attempt to obscure their true financial performance (e.g., make it appear more or less favorable) and to achieve particular financial goals. Bank managers have a number of motivations to manage their reported earnings. According to the incomesmoothing hypothesis, so as to stabilize earnings and reduce their volatility over the business cycle, banks would have incentives to overstate loan loss provisions under favorable economic conditions (e.g., during an expansion period) when their incomes are generally increasing, and understate loan loss provisions during difficult economic times (e.g., in a downturn) when they experience declining earnings. In addition, Greenawalt and Sinkey Jr. (1988) argue that bank managers have other motives to smooth income. …

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