Exploring earnings management by banks using the loan loss provision

A substantial number of studies have examined whether managerial discretion in determining the loan loss provision has been used to manage bank earnings. The results have been inconsistent. In an effort to correct some of the perceived deficiencies of prior investigations, this study incorporates a rigorous model of the non-discretionary component of the loan loss provision that specifically reflects bank supervisory guidance; uses quarterly, bank-level data; conducts analysis on a quarter-by-quarter, cross-sectional basis; and examines two five-year periods. The study first explicitly models the "nondiscretionary" component of the loan loss provision utilizing seven key factors contained in the formal guidance. It then incorporates that model of the nondiscretionary loan loss provision in its analyses designed to detect whether bank managers use their discretion in determining the reported loan loss provision and/or securities gains and losses in order to manage reported income or meet capital targets.; The results from the analysis demonstrate that the factors indicated in the supervisory guidance consistently play a material role in the determination of the loan loss provision during the periods analyzed. The robustness of the results regarding the nondiscretionary component of the loan loss provision strongly suggests that banks are complying with the supervisory guidance, which itself reflects a risk-management approach to the loan loss reserve. This analysis of earnings management behavior banks, which models the "nondiscretionary" component of the loan loss provision to reflect supervisory guidance from bank regulators, provides no support for the widespread belief in the systematic use of discretion in determining the reported loan loss provision to manage capital or to smooth earnings.