Bank Earnings Management Through Loan Loss Provisions: A Double-Edged Sword?

Abstract

We investigate the role of loan loss provisions (LLPs) for bank earnings management and risk provisioning. First, banks use LLPs to reduce the volatility of their earnings and banks with less volatile regulatory capital requirements have also less volatile earnings. Second, LLPs are higher when discretionary earnings are high and lower when regulatory capital requirements have decreased. Third, dividend-paying banks manage their earnings upward. Our findings highlight an important trade-off in banks’ provisioning for expected and unexpected losses that influences profitability, risk and payout policies.

Keywords: Bank risk, Earnings management, Bank capital, Discretion, Payout policy

JEL Classification: G21, G28, G34, M41