Strategic usefulness of ignorance: evidence from income smoothing via retained interest of securitized loans

Ignorance can be an advantage to a player if it is recognized and taken into account by an opponent…

- Thomas Schelling, The Strategy of Conflict (1960).

Abstract

This paper examines the notion of strategic ignorance in an earnings management context. Managers possess less information about loans subjected to securitization and auditors are aware of this shortcoming. Consistent with managers exploiting their own ignorance strategically and using loan loss provisions (LLP) of retained seller’s interest of securitized loans (SIL) more for earnings management than LLP of other loans, we find the use of LLP for income smoothing to be greater for banks that hold SIL. Moreover, the propensity to smooth income via LLP is increasing in the ratio of SIL to total loans. We also find that SIL is particularly useful for income smoothing in the fourth quarter, when greater auditor scrutiny makes it more difficult to manage earnings via LLP of non-securitized loans.

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Notes

  1. 1.

    In our sample, the average percentage of SIL to total loans outstanding is 6.18% for banks with SIL.

  2. 2.

    This reduced effort is not necessarily an outcome of agency conflicts between managers and shareholders. Rather, the relative cost–benefit tradeoff with respect to monitoring of non-securitized versus securitized loans will lead managers to put relatively less emphasis on the latter.

  3. 3.

    The argument here is that reduced need to engage in costly monitoring is one benefit of securitization, and auditors will not be able to impose stringent monitoring requirements on these loans. The extant literature on lax screening and monitoring of securitized loans is consistent with this notion (Keys et al. 2010; Purnanandam 2011; Mian and Sufi 2009; Wang and Xia 2014).

  4. 4.

    Lower monitoring is a potential benefit of securitization because monitoring is costly.

  5. 5.

    From an audit procedure standpoint, this can be thought of as auditors allowing a higher “tolerable misstatement limit” for SIL LLP. See, Kilic et al (2013, p. 249–250) for a discussion on tolerable misstatement limits in the context of provisioning for loan losses.

  6. 6.

    Experimental game theory studies report similar findings of strategic usefulness of ignorance. For example, Conrads and Irlenbusch (2013) find that ignorance of a player elicits concessions from other players in strategic games. In a setting of an ultimate bargaining game, they show that a responder is more likely to accept a low offer from a proposer if the responder believes that the proposer is ignorant about the final payoff to the responder. Dana et al. (2007) show in an experiment involving a modified version of the well-known dictator’s game that the dictator acts significantly more selfishly when the receiver is unsure about whether or not the given outcome is within the dictator’s control.

  7. 7.

    Rogers and Stocken (2005) is one exception in the voluntary disclosure domain. Although Rogers and Stocken (2005) do not explicitly discuss the notion of strategic ignorance, they find that managers are more likely to provide biased forecasts when firms’ earnings are associated with greater uncertainty, which is consistent with such behavior.

  8. 8.

    Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) imposed new auditing, corporate reporting, and governance reforms on depository institutions with assets exceeding $500 million, and the asset threshold increased to $1 billion in 2005.

  9. 9.

    Other refers to “all other loans” as defined in Schedule HC-C of Y-9C. The sum of Realestate, Commerical, Consumer, and Other loans does not equate to total loans as it excludes items such as loans to depository institutions and loans to foreign governments and official institutions.

  10. 10.

    The mean values of total assets for the full sample and for the subsample of banks with SIL are $26 billion and $485 billion, respectively.

  11. 11.

    Note that for this subsample analysis we cannot use the binary variable SIL because all banks in the sample carry SIL. Therefore, we only use the fraction of SIL in the loan portfolio (SIL-fraction).

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Appendix

Appendix

See Table 9.

Table 9 Variable definitions

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Kilic, E., Lobo, G., Ranasinghe, T. et al. Strategic usefulness of ignorance: evidence from income smoothing via retained interest of securitized loans. Rev Quant Finan Acc 56, 245–272 (2021). https://doi.org/10.1007/s11156-020-00892-y

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Keywords

  • Strategic ignorance
  • Income smoothing
  • Loan loss provisions
  • Securitization
  • Seller’s interest loans

JEL Classification

  • M41
  • G21
  • D91