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).
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.
This is a preview of subscription content, access via your institution.
We’re sorry, something doesn't seem to be working properly.
Please try refreshing the page. If that doesn't work, please contact support so we can address the problem.
In our sample, the average percentage of SIL to total loans outstanding is 6.18% for banks with SIL.
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.
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).
Lower monitoring is a potential benefit of securitization because monitoring is costly.
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.
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.
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.
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.
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.
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.
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).
Alali F, Jaggi B (2011) Earnings versus capital ratios management: role of bank types and SFAS 114. Rev Quant Finance Account 36(1):105–132
Altamuro J, Beatty A (2010) How does internal control regulation affect financial reporting? J Account Econ 49(1–2):58–74
Barth ME, Ormazabal G, Taylor DJ (2012) Asset securitizations and credit risk. Account Rev 87(2):423–448
Beck PJ, Narayanamoorthy GS (2013) Did the SEC impact banks’ loan loss reserve policies and their informativeness? J Account Econ 56(2–3):42–65
Bhat G, Lee JA, Ryan SG (2016) Using loan loss indicators by loan type to sharpen the evaluation of the determinants and implications of banks’ loan loss accruals. Working paper
Brown LD, Pinello AS (2007) To what extent does the financial reporting process curb earnings surprise games? J Account Res 45(5):947–981
Collins JH, Shackelford DA, Wahlen JM (1995) Bank differences in the coordination of regulatory capital, earnings, and taxes. J Account Res 33(2):263–291
Comptroller of the Currency, Administor of National Banks (1997) Asset securitization. Comptroller’s handbook
Conrads J, Irlenbusch B (2013) Strategic ignorance in ultimatum bargaining. J Econ Behav Organ 92:104–115
Dana J, Weber RA, Kuang JX (2007) Exploiting moral wiggle room: experiments demonstrating an illusory preference for fairness. Econ Theor 33:67–80
Dechow PM, Shakespeare C (2009) Do managers time securitization transactions to obtain accounting benefits? Account Rev 84(1):99–132
Dechow PM, Myers LA, Shakespeare C (2010) Fair value accounting and gains from asset securitizations: a convenient earnings management tool with compensation side-benefits. J Account Econ 49(1–2):2–25
Department of the Treasury, Federal Reserve System, Federal Deposit Insurance Corporation, Federal Housing Finance Agency, U.S. Securities and Exchange Commission, Department of Housing and Urban Development (2011) Credit risk retention
Dye RA (1985) Disclosure of nonproprietary information. J Account Res 23(1):123–145
FDIC (2007) Credit card securitization manual. https://www.fdic.gov/regulations/examinations/credit_card_securitization/
Gebhardt G, Novotny-Farkas Z (2011) Mandatory IFRS adoption and accounting quality of European banks. J Bus Finance Account 38(3–4):289–333
Graham JR, Harvey CR, Rajgopal S (2005) The economic implications of corporate financial reporting. J Account Econ 40(1–3):3–73
Jung W, Kwon YK (1988) Disclosure while market is unsure of information endowment of managers. J Account Res 26(1):146–153
Kanagaretnam K, Lobo GJ, Mathieu R (2003) Managerial incentives for income smoothing through bank loan loss provisions. Rev Quant Finance Account 20(1):63–80
Kanagaretnam K, Lobo GJ, Yang D (2004) Joint tests of signaling and income smoothing through bank loan loss provisions. Contemp Account Res 21(4):843–884
Kanagaretnam K, Krishnan GV, Lobo GJ (2010a) An empirical analysis of auditor independence in the banking industry. Account Rev 85(6):2011–2046
Kanagaretnam K, Lim CY, Lobo GJ (2010b) Auditor reputation and earnings management: international evidence from the banking industry. J Bank Finance 34(10):2318–2327
Kessler AS (1998) The value of ignorance. Rand J Econ 29(2):339–354
Keys BJ, Mukherjee T, Seru A, Vig V (2010) Did securitization lead to lax screening? Evidence from subprime loans. Q J Econ 125(1):307–362
Kilic E, Lobo GJ, Ranasinghe T, Sivaramakrishnan K (2013) The impact of SFAS 133 on income smoothing by banks through loan loss provisions. Account Rev 88(1):233–260
Kwak W, Lee H, Mande V (2009) Institutional ownership and income smoothing by Japanese banks through loan loss provisions. Rev Pac Basin Financ Mark Pol 12(2):219–243
Liu C, Ryan SG (1995) The effect of bank loan portfolio composition on the market reaction to and anticipation of loan loss provisions. J Account Res 33(1):77–94
Liu C, Ryan SG (2006) Income smoothing over the business cycle: changes in banks’ coordinated management of provisions for loan losses and loan charge-offs from the pre-1990 bust to the 1990s boom. Account Rev 81(2):421–441
Lobo GJ, Yang D (2001) Bank managers’ heterogeneous decisions on discretionary loan loss provisions. Rev Quant Finance Account 16(3):223–250
Ma CK (1988) Loan loss reserves and income smoothing: the experience in the U.S. banking industry. J Bus Finance Account 15(4):487–497
Mamun A, Alam MD, Tannous G (2019) Did the regulatory changes of 1999 and 2001 affect income smoothing behavior of US banks? Rev Quant Finance Account 52(4):1011–1041
Mian A, Sufi A (2009) The consequences of mortgage credit expansion: evidence from the U.S. mortgage default crisis. Q J Econ 124(4):1449–1496
Purnanandam A (2011) Originate-to-distribute model and the subprime mortgage crisis. Rev Financ Stud 24(6):1881–1915
Rogers JL, Stocken PC (2005) Credibility of management forecasts. Account Rev 80(4):1233–1260
Ryan SG (2012) Financial reporting for financial instruments. Found Trends Account 6(3–4):187–354
Sarkisyan A, Casu B (2013) Retained interests in securitisations and implications for bank solvency. Working paper, European Central Bank
Schelling TC (1956) An essay on bargaining. Am Econ Rev 46(3):281–306
Schelling TC (1960) The strategy of conflict. Harvard University Press, Cambridge
Schipper K (1989) Commentary on earnings management. Account Horiz 3(4):91–102
Wahlen JM (1994) The nature of information in commercial bank loan loss disclosures. Account Rev 69(3):455–478
Wang Y, Xia H (2014) Do lenders still monitor when they can securitize loans? Rev Financ Stud 27(8):2354–2391
Springer Nature remains neutral with regard to jurisdictional claims in published maps and institutional affiliations.
See Table 9.
About this article
Cite this article
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
- Strategic ignorance
- Income smoothing
- Loan loss provisions
- Seller’s interest loans