Bank loan loss provisions: a reexamination of capital management, earnings management and signaling effects

TLDR

The study exploits the 1990 capital adequacy regulation change to test whether bank loan loss provisions are used for capital and earnings management. It constructs more powerful tests of these effects by leveraging the regulatory shift. The results show that loan loss provisions are employed for capital management, provide no evidence of earnings management through provisions, explain why prior studies reached conflicting conclusions, and reveal that provisions are negatively associated with future earnings changes and contemporaneous stock returns, contradicting earlier signaling results.

Abstract

This paper exploits the 1990 change in capital adequacy regulations to construct more powerful tests of capital and earnings management effects on bank loan loss provisions. We find strong support for the hypothesis that loan loss provisions are used for capital management. We do not find evidence of earnings management via loan loss provisions. We also document the reasons for the conflicting results on these effects observed in prior studies. Additionally, we find that loan loss provisions are negatively related to both future earnings changes and contemporaneous stock returns contrary to the signaling results documented in prior work.