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Banks’ Income Smoothing in the Basel Period: Evidence from European Union

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Economic and Financial Challenges for Eastern Europe

Part of the book series: Springer Proceedings in Business and Economics ((SPBE))

Abstract

This paper investigates whether European banks smooth income and regulatory capital ratios through loan loss provisions in the Basel period. Using a sample of 1064 bank-year observations from 26 European Union countries, we find that banks use loan loss provisions in order to smooth income after the adoption of IFRS and the Basel regulatory framework. However, our results do not support the regulatory capital management hypothesis. In addition, we find that the risk level and direct market discipline affect bank managers’ accounting discretion. On the other hand, we do not find evidence to support the hypothesis that the legal environment plays a substantial role in banks’ accounting policy decisions.

This research is financed by the Research Centre of Athens University of Economics and Business, in the framework of the project entitled “Original Scientific Publications.”

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Notes

  1. 1.

    In May 2006, the Public Company Accounting Oversight Board (PCAOB) issued a report on large firms accounting deficiencies. The American Institute of Certified Public Accountants (AICPA 2006) found that banks’ loan loss allowance ranks number one among the various deficiencies found by inspectors.

  2. 2.

    The increase of loan loss provisions by 1 euro would lead to an equal decline of earnings and capital by 1 × (1-tax rate). Also, capital will increase by 1 euro since loan loss provisions would be added back to capital.

  3. 3.

    This hypothesis was suggested by Bishop (1996) and suggests that regulators are reluctant to intervene in operations of large banks.

  4. 4.

    Laeven and Majnoni (2003) argued that income smoothing through loan loss provisions is suggested by regulators in order to offset pro-cyclical effect of banks’ capital. Within this context, they argue that when loan loss provisions are negatively associated with GDP growth, bank managers show an imprudent loan loss provisioning behavior.

  5. 5.

    Common-law countries have the strongest protection of outside investors, both shareholders and creditors, whereas French civil law countries have the weakest protection. German civil law and Scandinavian countries fall in between, although comparatively speaking they have stronger protection of creditors, especially secured creditors.

  6. 6.

    Laeven and Majnoni (2003) argue that loan loss provisioning behavior is susceptible to have pro-cyclical effect on banks’ capital if loan loss provisions are negatively related to loan growth or GDP growth.

  7. 7.

    They provide the example of Citigroup who disclosed in their SEC filings a target Tier 1 capital ratio of 7.5% which is substantially above the 6% required to be considered “well capitalized”.

  8. 8.

    We perform the same tests by excluding the observations from the 33rd to the 66th percentile, and we find the same results.

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Authors and Affiliations

  1. Athens University of Economics and Business, Athens, Greece

    Konstantinos Vasilakopoulos, Christos Tzovas & Apostolos A. Ballas

Authors
  1. Konstantinos Vasilakopoulos
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  2. Christos Tzovas
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  3. Apostolos A. Ballas
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Correspondence to Konstantinos Vasilakopoulos .

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Editors and Affiliations

  1. Piraeus University of Applied Sciences, Egaleo, Greece

    Nicos Sykianakis

  2. International Hellenic University, Serres, Greece

    Persefoni Polychronidou

  3. International Hellenic University, Kavala, Greece

    Anastasios Karasavvoglou

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Vasilakopoulos, K., Tzovas, C., Ballas, A.A. (2019). Banks’ Income Smoothing in the Basel Period: Evidence from European Union. In: Sykianakis, N., Polychronidou, P., Karasavvoglou, A. (eds) Economic and Financial Challenges for Eastern Europe. Springer Proceedings in Business and Economics. Springer, Cham. https://doi.org/10.1007/978-3-030-12169-3_4

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