A Re-Examination of Income Smoothing in Banks
64 Pages Posted: 18 Mar 2021
Date Written: March 9, 2021
Previous studies document discretionary income smoothing in banks via the association between loan loss provisions and pre-provision earnings. In this study, we argue that there is a large non-discretionary component to the association that is driven by the positive relationship between risk and return. Including loan interest as a control for risk significantly attenuates the coefficient on pre- provision earnings in models explaining loan loss provisions. We draw upon the non-bank literature on earnings smoothing to construct a new measure of discretionary income smoothing. We validate our measure using an exogeneous shock to income smoothing in a short window surrounding the SEC's intervention in bank accounting in the late 1990's. Employing this new measure, we provide evidence that discretionary smoothing is associated with more informative loan loss provisions, inconsistent with the notion prevalent in recent studies that smoothing is associated with lower transparency.
Keywords: loan loss provisions, smoothing, transparency, financial system stability
JEL Classification: G21, M41
Suggested Citation: Suggested Citation