Bank earnings and capital management and early warning systems: evidence from OCED countries

Abstract

Loan loss provisions (LLPs) are a large accrual for banks that, via discretionary adjustment, can have a significant impact on earnings and capital. In chapter 2, I study whether banks use LLPs to manage earnings in order to satisfy their earnings, capital and signalling incentives before, during and after the financial crisis 2007-09 (crisis). I also compare the difference between listed and unlisted banks as well as between European and US banks. In order to investigate earnings and capital management, I utilise balance sheet and income statement data from 4,472 banks in 14 OECD countries covering 1989 – 2016 and construct a comprehensive and novel database to address these incentives. Overall, I find that banks use LLPs for earnings and capital management. Banks engage in earnings management more in the post-crisis period. Listed banks adopt earnings management more aggressively during the crisis. European banks engage in earnings management more than US banks. By contrast, US banks engage in capital management more than European banks. Finally, banks appear to use LLPs to signal good news about future earnings during the crisis. Available-for-sale securities (AFS) constitute the largest component of banks’ securities1 and account for a considerable percentage of bank assets (Barth et al., 2017). Furthermore, the discretionary realisation of AFS securities enables banks to manage earnings and capital. Chapter 3 examines whether banks in OECD countries use realized gains and losses on AFS securities for earnings management (income smoothing, taking a big bath and avoiding earnings losses) and capital management during and post-crisis periods. I utilise balance sheet and income statement data from 1,932 banks in 14 OECD countries over the period 2007-2017. Overall, I find banks engage in income smoothing; banks have higher incentives to smooth income when they have more opportunities. However, low regulatory capital mitigates positive earnings banks’ incentives to smooth income. Moreover, banks use AFS securities to avoid reporting earnings losses. Banks with low regulatory capital realise more gains to increase regulatory capital when banks have opportunities. Finally, income smoothing, avoiding losses, and capital management are dominated by unlisted banks. By contrast, listed banks have higher incentives to smooth earnings when they have more opportunities. Banking crises are damaging and contagious; they significantly impact the economy and lead to a deep and long-lasting recession. Previous studies have estimated substantial output loss in OECD countries experiencing banking crises over the period 2007-2011. Consequently, extensive research has studied the indicators of the Early Warning Systems for banking crises. In chapter 4, unlike many studies focusing on economics and financial variables, I use balance sheet and income statement data to construct variables used in the logit model to predict banking crises. The evidence shows that along with liquidity and leverage ratios, changes in discretionary LLPs improve the prediction of systemic banking crises.