Discretion in Bank Loan Loss Allowance, Risk Taking, and Earnings Management

33 Pages Posted: 26 Dec 2015

See all articles by Justin Yiqiang Jin

Justin Yiqiang Jin

McMaster University - DeGroote School of Business

Kiridaran (Giri) Kanagaretnam

York University - Schulich School of Business

Gerald J. Lobo

University of Houston - C.T. Bauer College of Business

Date Written: August 1, 2015

Abstract

We study whether bank managers’ use their discretion in estimating the allowance for loan losses (ALL) for efficiency or for opportunistic reasons. We do so by examining whether the use of this discretion relates to bank stability and bank risk taking, or whether it relates to earnings management to meet or beat earnings benchmarks. We find that banks that had higher abnormal ALL during the period prior to the 2007-2009 financial crisis engaged in less risk taking during the pre-crisis period and had a lower probability of failure during the crisis period. In tests related to earnings management to meet or beat earnings benchmarks, we find that abnormal ALL is unrelated to next period’s loss avoidance and just meeting or beating the prior year’s earnings. Our results suggest that bank managers use their discretion over ALL for efficiency and not for opportunistic purposes. They inform policy makers and accounting standard setters on banks’ use of accounting discretion as a means to build a cushion against future credit losses as they transition from the incurred loss model to the expected loss model for loan loss accounting.

Keywords: Loan Loss Allowance, Risk Taking, Financial Crisis, Earnings Management, Expected Loss Model

JEL Classification: G14, G21, M41, M42

Suggested Citation

Jin, Justin Y. and Kanagaretnam, Kiridaran and Lobo, Gerald J., Discretion in Bank Loan Loss Allowance, Risk Taking, and Earnings Management (August 1, 2015). Available at SSRN: https://ssrn.com/abstract=2708318 or http://dx.doi.org/10.2139/ssrn.2708318

Justin Y. Jin

McMaster University - DeGroote School of Business ( email )

1280 Main Street West
Hamilton, Ontario L8S 4M4
Canada
905-525-9140 ext. 26194 (Phone)
905-521-8995 (Fax)

Kiridaran Kanagaretnam (Contact Author)

York University - Schulich School of Business ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada

Gerald J. Lobo

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States
713-743-4838 (Phone)
713-743-4828 (Fax)

HOME PAGE: http://www.bauer.uh.edu/acct/acctprofile.asp?search=Gerald%20Lobo

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