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

49 Pages Posted: 5 Nov 2008

See all articles by Chi-Chun Liu

Chi-Chun Liu

National Taiwan University

Stephen G. Ryan

New York University (NYU) - Leonard N. Stern School of Business

Date Written: May 2003

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 non-discretionary nature of these charge-offs.

Keywords: Income smoothing, business cycle, banks, provisions for loan losses, loan charge-offs

Suggested Citation

Liu, Chi-Chun and Ryan, Stephen G., 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 (May 2003). NYU Working Paper No. S-CDM-03-15, Available at SSRN: https://ssrn.com/abstract=1295793

Chi-Chun Liu

National Taiwan University ( email )

No. 1, Roosevelt Road, Sec. 4,
Taipei 106
Taiwan

Stephen G. Ryan

New York University (NYU) - Leonard N. Stern School of Business ( email )

44 West 4th Street, Suite 10-73
New York, NY 10012-1118
United States
212-998-0020 (Phone)

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