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Earnings versus capital ratios management: role of bank types and SFAS 114

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Abstract

We document in this paper that large banks use Loan Loss Provisions (LLP) more than small banks to manage reported earnings, but we find no significant difference in the use of LLP to manage capital ratios between large and small banks. Additionally, we document that banks with high risk asset portfolios use more LLP to manage reported earnings as well as capital ratios compared to the banks with low risk asset portfolios. Our findings also show that SFAS 114 has a moderating effect on the use of LLP to manage reported earnings, especially by large banks, but there is no conclusive evidence on the impact of SFAS 114 to manage capital ratios. Furthermore, the findings show that there has been significantly more earnings management during the 2007–2008 financial crisis compared to earlier periods.

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Notes

  1. Arguments for this conjecture are provided in the section on the Hypothesis Development.

  2. We conducted additional analyses on the sub-samples of pre- and post-SFAS 114 and using 2000–2006 to represent the pre-financial crisis period and 2007–2008 to represent the financial crisis period. The results show that SFAS 114 significantly constrained managerial behavior of earnings management during the post-SFAS 114 period and that earnings management has increased during the financial crisis period. Our results are inconclusive with regard to the use of LLP to manage capital ratios during the financial crisis period. Our results are also robust when an alternative model specification is used and other alternative tests are conducted.

  3. Under the capital regulations, banks are allowed to include loan loss allowance in the numerator of the tier 2 ratios (and therefore becomes part of total capital ratios), up to 1.25% of risk-weighted assets. An insignificant relationship between LLP and capital ratios may, therefore, mean that the bank is unable to raise capital ratios as it has reached the 1.25% limit. LLP also have different impacts on Tier 1 and Tier 2 ratios. In fact, increase in LLP will result in lower Tier 1 ratio and leverage ratio, suggesting a negative relationship. On the other hand, increase in LLP will result in higher Tier 2 ratio (and thus Total Capital ratio), suggesting a positive relationship. In this study, following FDICIA Act, we use an indicator variable that equals to 1 if a bank fails any of the required regulatory minimum ratios and zero otherwise.

  4. Finding insignificant evidence may indicate that the increased analysts following and market scrutiny of large banks play as deterrent factors in managerial discretionary behavior.

  5. Three categories of undercapitalization are specified by the FDICIA, i.e. undercapitalized, significantly undercapitalized, and critically undercapitalized. The least severe case of undercapitalization is when a bank falls below 4% for tier 1 risk based capital ratio or 4% leverage ratio or 8% for total capital risk based ratio. We use these cut-offs to classify banks as undercapitalized. Loan loss allowance is a component of Tier 2 ratio which is also a component of the Total capital ratio.

  6. However, SFAS 114 has limited scope because only large groups of homogenous loans that are collectively evaluated for impairment, such as smaller commercial loans, credit card loans, residential mortgages and consumer installment loans, are not included within the scope of SFAS No. 114. The SEC issue SAB 102 “Selected Loan Loss Allowance Methodology and Documentation Issues”, July 2001.

  7. In our additional analyses section, we also consider alternative size categories, including size indicator variable relative to the sample median and a continuous variable using natural logarithm of total assets at the end of the year. Our results remain qualitatively the same or stronger.

  8. Reducing prime interest rate and subsequently interest rates adjusted for different types of risk has been a strategy used by the Federal Reserve Bank to revive the economy in downturn times. Laeven and Majnoni (2003), Cavallo and Majnoni (2002) discuss the relationship between economic downturns, and levels of capital and adequacy/inadequacy of loan loss allowance.

  9. To avoid multicollinearity with LRGD, we exclude Size variable from the models testing LRGD effect on the relationship between earnings and capital ratios.

  10. Banks can recognize LLP and include it in the tier 2 capital ratio calculation as long as the allowance for loan losses is ≤1.25% of risk weighted assets. If this limit is reached, then there is no benefit to recognize more LLP. This is the effect on tier 2 and therefore total capital ratios. Total capital ratio is the sum of tier 1 and tier 2 ratios with some restrictions on the total amount of tier 2 that can count in total capital ratio. Therefore, using LLP to manage tier 2 ratio affects total capital ratio.

  11. Model (4) in Table 6 also shows the interaction variable of UCAPEBTP is positive and marginally significant at the 5 percent level suggesting that on average, banks do consider the combined effect of LLP on capital ratios and earnings. This coefficient also provides evidence on the use of LLP to manage earnings in order to alter the capital ratios.

  12. This model has been suggested by a reviewer.

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Authors and Affiliations

  1. Department of Accounting, California State University –Fullerton, Fullerton, CA, 92834, USA

    Fatima Alali

  2. Department of Accounting, Business Ethics & Information Systems, Rutgers University, The State University of New Jersey, Piscataway, NJ, 08854, USA

    Bikki Jaggi

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  1. Fatima Alali
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Correspondence to Bikki Jaggi.

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Alali, F., Jaggi, B. Earnings versus capital ratios management: role of bank types and SFAS 114. Rev Quant Finan Acc 36, 105–132 (2011). https://doi.org/10.1007/s11156-010-0173-4

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