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Bank earnings and regulatory capital management using available for sale securities

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Based on a large sample of publicly listed and non-listed US commercial banks from 1996 to 2011, we find robust evidence consistent with banks using realized available for sale (AFS) securities gains and losses to smooth earnings and increase low regulatory capital. We also find that (i) banks with positive earnings smooth earnings, and banks with negative earnings generally take big baths; (ii) regulatory capital constrains big baths; (iii) banks with more negative earnings and more unrealized beginning-of-quarter losses (gains) take big baths (smooth earnings); and (iv) banks with low regulatory capital and more unrealized gains realize more gains. Also, banks with negative earnings take big baths (avoid or reduce the earnings loss) if their unrealized gains are insufficient (sufficient) to offset the negative earnings. Our inferences apply to listed and non-listed banks, which indicates that the earnings management incentives do not derive solely from public capital markets. Our findings reveal that the accounting for AFS securities gains and losses enables banks to manage regulatory capital and earnings in a variety of ways.

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  1. We use the terms “earnings” and “net income” interchangeably.

  2. Securities held for sale were measured at the lower of cost or market. Held-for-sale securities comprised a small fraction of banks’ securities.

  3. Untabulated statistics based on our sample banks reveal that during this reclassification period, for approximately 80% (69%) of publicly listed (non-listed) banks the increase in AFS securities, as a percentage of total securities, was within 1% of the decrease in HTM securities.

  4. The regulatory treatment for unrealized AFS securities gains and losses is the same as for investment securities prior to ASC 320. This treatment was unchanged during our sample period, except that starting in 1998 banks are permitted, but not required, to include in Tier II capital 45% of unrealized gains on AFS equity securities. Untabulated statistics based on our sample banks reveal that the percentage of AFS equity securities is small; the median is zero and the 75th percentile is < 1%. Under Basel III, which became effective in 2014 after the end of our sample period, accumulated other comprehensive income is included in Tier 1 capital for some banks. Its inclusion is mandatory for banks that use the advanced approach in measuring risk-weighted assets; these typically are large banks, but other banks have a one-time opportunity to opt out of this requirement.

  5. Real earnings management involves managing earnings by entering into transactions that are reflected in financial reporting (Goel and Thakor 2003). Graham et al. (2005) reports results of a survey of chief financial officers that indicate real earnings management is more prevalent than accruals-based earnings management.

  6. Untabulated statistics reveal that, on average, banks classify 86% of non-trading securities as AFS, which represents 17% of total assets. Although trading securities represents 15% of total assets for the ten largest bank holding companies, it represents less than 0.06% for other banks; only 3% sample banks have trading securities.

  7. Dong et al. (2014) examines the equity pricing implications of realized AFS securities gains and losses for listed banks by estimating the relation between the gains and losses and next quarter’s earnings. The study finds that the gains and losses help predict earnings, but does not consider implications of earnings management for predictive ability.

  8. Several studies investigate whether banks use the loan loss provision to smooth earnings. See Wall and Koch (2000) for a summary of this literature. More recently, Kilic et al. (2013) finds that adoption of SFAS 133, which reduces banks’ ability to use derivatives to smooth earnings, is associated with increased use of the loan loss provision to smooth earnings. Some studies find that banks use the loan loss provision to manage regulatory capital (Moyer 1990; Beatty et al. 1995; Ahmed et al. 1999; Pérez et al. 2008). Other studies find that banks use gains on asset securitizations to manage earnings (Karaoglu 2005; Dechow and Shakespeare 2009; Dechow et al. 2010b). Section 5.5.1 considers whether simultaneous use of the loan loss provision and securitization gains to manage earnings and regulatory capital affects our inferences.

  9. The research design details in Lifschutz (2002) are insufficient to replicate that study’s analysis. For example, Lifschutz (2002) defines return on assets as “profitability to assets of income before tax and before net gains.” We assume income is net income before taxes and realized AFS securities gains and losses, which is the definition we use, and assets is end-of-quarter total assets. We follow Lifschutz’s (2002) sample construction as we understand it, except that we retain banks without complete data for all 16 quarters; doing so is necessary to replicate the significant negative coefficients on the performance measures. Our procedures result in 1471 observations for 117 banks and a t-statistic associated with return on assets (equity) of −1.91 (−2.30), which would support the conclusion in Lifschutz (2002). However, clustering residual standard errors by bank and year-quarter when constructing t-statistics reveals an insignificant relation; the t-statistic for the return on assets (equity) coefficient is −0.75 (−0.95). Including bank fixed effects in the estimation equation reveals either a significant positive relation or an insignificant relation, depending on whether we also double-cluster residual standard errors. The t-statistic for the return on assets (equity) coefficient is 2.93 (1.73) without also double-clustering standard errors, and 1.58 (1.02) with double-clustered standard errors. None of these statistics support the conclusions in Lifschutz (2002).

  10. Few bank-quarter observations have regulatory capital below the required minimum. See footnote 13. Thus, the incentive to avoid violating minimum regulatory capital requirements largely is not present in our sample.

  11. Scholes et al. (1990 SWW) also finds a significant negative relation between realized securities gains and losses and the loan loss provision. Although SWW interprets this finding as meaning banks use realized securities gains and losses to smooth earnings by offsetting the earnings effect of the loan loss provision, SWW does not provide evidence directly supporting this interpretation.

  12. For ease of exposition, we use the same notation for coefficients and error terms in each equation.

  13. We use the lowest decile because only 1012 observations relating to 300 banks, of 136,879 observations for 6300 banks, have regulatory capital before RGL and after taxes, RegCap, less than the required level of 8%. Because violating regulatory capital is a serious matter for banks, most maintain a buffer above the required minimum, which is unobservable (Amel-Zadeh et al. 2017). Thus, what level to use is an empirical matter. Untabulated statistics reveal that mean RegCap in the lowest decile, i.e., those observations for which RegCapLow equals one, is 10%, whereas the mean in the highest decile is 45%, which largely is attributable to some banks holding assets with low risk weights. Untabulated findings also reveal that using the lowest two or lowest five deciles reveals inferences consistent with those revealed by the tabulated results. However, the significance levels are somewhat lower for the tabulated results, which supports the empirical validity of using the lowest decile.

  14. In untabulated analyses we alternately include, in all specifications, four proxies for growth—changes in total interest income and total assets between the current quarter and one and four quarters prior. We do not include these variables in the tabulated findings because their construction results in a loss in sample size.

  15. We define “big bath” earnings management as banks with more negative earnings before realized AFS securities gains and losses realizing more losses or fewer gains. We do not define it as only realizing more losses, as is common in the accruals-based earnings management literature, because realizing AFS securities gains and losses to manage earnings is a type of real earnings management with direct cash flow implications. Negative accruals recognized to achieve big bath earnings management reverse in future periods, which is not the case for realized securities losses. Rather, we expect banks with negative earnings that sell AFS securities to select securities with unrealized losses or with smaller unrealized gains, thereby enhancing their ability to realize larger gains in future periods.

  16. We do not include NIpos×UG t−1 and RegCapLow×UL t−1 in Eq. (2) because we have no predictions for the signs of their coefficients. Untabulated findings reveal that including these variables does not affect our inferences. The only difference is that the RegCapLow coefficient has the predicted sign (t-stat. = 1.34).

  17. All commercial banks file regulatory reports. Bank holding companies control, directly or indirectly, one or more commercial banks. A bank holding company can control another bank holding company, which controls commercial banks. The top holder is the entity that tops the control chain, which could be a commercial bank.

  18. ASC 320 required the classification of securities into trading, available for sale, and held to maturity beginning in 1994. Untabulated findings reveal that beginning the sample in 1994 does not affect our inferences.

  19. The sum of 728 and 5862 exceeds 6300 because 290 banks changed status during the sample period.

  20. Realized gains and losses on AFS securities, RGL, comprises gains and losses realized by sale or other disposal of the securities and losses arising from other than temporary impairment (OTTI) of the securities. The timing and amount of sales or other disposals are discretionary, and those of OTTI require application of management judgement. Thus, both can be used to manage earnings.

  21. Beginning in 2009, listed banks must disclose gross unrealized gains and losses on AFS securities in Form 10-Q. Although some listed banks disclosed the amounts before this date, the disclosures are not available for non-listed banks or throughout our sample period. To assess the validity of UG and UL in capturing gross unrealized gains and losses, we hand-collected the gross amounts for 4071 bank-quarter observations for 461 banks from 2005 to 2011. Untabulated statistics reveal that the median ratio of gross unrealized gains (losses) on AFS securities to UG (UL) is 1.23 (1.18), which indicates that UG (UL) understates the gross amounts by 23% (18%). However, untabulated findings from estimating Eq. (2) using the hand-collected data when available, and UG and UL otherwise, reveal the same inferences as those revealed by the tabulated findings.

  22. We use the term “significant” to denote statistical significance at the 5% level based on a one-sided test when we have a signed prediction and a two-sided test otherwise.

  23. Prior research (e.g., Scholes et al. 1990) considers tax incentives for banks to realize securities gains and losses. Beatty and Harris (1998) includes in its equation analogous to Eq. (1) an indicator variable that equals one if the bank reports positive tax expense before the tax on realized securities gains, and zero otherwise. This variable is not available during our sample period. Instead, we re-estimate Eq. (1) including an alternative tax indicator variable that equals one if the bank has positive tax expense, and zero otherwise. Untabulated findings reveal that its inclusion yields inferences consistent with those we obtain from Eq. (1). The t-statistics associated with the untabulated NI, RegCapLow, and NI×RegCapLow coefficients are −5.37, 1.36, and −0.18.

  24. Section 5.5.3 reports findings from additional analyses that indicate this unpredicted sign is attributable to assuming all NIpos banks have the same incentives for earnings management, namely to smooth earnings, whereas some might have earnings management benchmarks other than zero earnings.

  25. As footnote 4 explains, 45% of unrealized gains and losses on equity AFS securities affect regulatory capital. Although this reduces banks’ ability to affect regulatory capital by realizing gains and losses on AFS securities, equity securities comprise a small proportion of AFS securities for our sample. Nonetheless, we re-estimated the five specifications of Eqs. (1) and (2) in Tables 2 and 3 including an indicator variable, Q5, which equals one if the bank’s ratio of AFS equity securities to total AFS securities is in the highest quintile across banks in quarter t and zero otherwise, and Q5 interacted with RegCapLow, RegCapLow×Q5. Consistent with banks with low regulatory capital and more AFS equity securities realizing fewer gains, but also with the estimations lacking power, untabulated statistics reveal that the RegCapLow×Q5 coefficients are negative, but not significantly so, in all five specifications (t-statistics range from −0.71 to −1.51). The untabulated statistics reveal the same inferences regarding RegCapLow as those based on Tables 2 and 3; the t-statistics are 1.96 and 1.88 in the Table 2 specifications and 2.51, 1.48, and −1.66 in the Table 3 specifications.

  26. Untabulated findings based on a specification that permits all coefficients to differ for loss avoiders reveal the same inferences as the findings in panel C.

  27. Untabulated statistics from estimations of the two versions of Eq. (1) but permitting only the NI, RegCapLow, and NI×RegCapLow coefficients to vary for listed banks reveal inferences identical to those from the estimation that permits all coefficients to vary. The t-statistics are 0.26 and 0.10 (1.30 and 0.86) for the incremental NI (RegCapLow) coefficients for listed banks; the t-statistic for the incremental NI×RegCapLow coefficient is 0.30.

  28. Untabulated statistics from estimations permitting only the NIneg, NIpos, RegCapLow, and NI×RegCapLow coefficients to vary for listed banks reveal the same inferences as the estimation that permits all coefficients to vary.

  29. In the first stage, we estimate versions of Eqs. (3a) through (3d) that include all of the explanatory variables in the system, except for RGL, LLP, SG, and ΔEqFin. In the second stage, we estimate Eqs. (3a) through (3d) replacing RGL, LLP, SG, and ΔEqFin as explanatory variables with their predicted amounts from the first stage.

  30. We do not use analyst earnings forecasts because analyst forecasts are not available for many banks, particularly non-listed ones. We do not use the 8% required regulatory capital ratio because, as footnote 13 explains, few observations have regulatory capital before RGL and taxes less than 8%.


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We appreciate the helpful comments and suggestions from Michael Minnis, Doron Nissim, Stephen Penman, and seminar participants at the American Accounting Association annual meeting, especially John McInnis the discussant; Barcelona Accounting Seminar Series; European Accounting Association Annual Congress; Spanish Finance Association annual conference, especially Ricardo Gimeno the discussant; Universidad de Navarra; University of Neuchatel; Universitat Pompeu Fabra; Universidad de Valladolid; and the VII International Research Symposium for Accounting Academics (Madrid), especially Pedro J. García the discussant. We also appreciate the data collection efforts of Min Ji Lee. Germán López-Espinosa (Javier Gomez-Biscarri) acknowledges financial support from the Ministerio de Ciencia e Innovación project ECO2012-33619 (ECO-2014-55488-P & SEV-2015-0563) and from the Gobierno de Navarra Jerónimo de Ayanz program (Barcelona GSE).

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Correspondence to Mary E. Barth.



Table 7 Variable definitions

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Barth, M.E., Gomez-Biscarri, J., Kasznik, R. et al. Bank earnings and regulatory capital management using available for sale securities. Rev Account Stud 22, 1761–1792 (2017).

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