Bank earnings management through loan loss provisions: a double-edged sword?

We investigate whether banks use of loan loss provisions (LLPs) to manage the level and volatility of their earnings and examine the implications for bank risk. We find that banks use LLPs to manage the level and volatility of earnings downward when they are abnormally high and when expected dividends are lower than current earnings. Moreover, banks adjust LLPs to avoid fluctuations in their risk-weighted assets. Our findings highlight an important tradeoff in the provisioning for expected and unexpected losses that affects bank risk and profitability.
 
Keywords: Loan loss provisions, Bank risk, Earnings smoothing, Discretion, Payout policy.
JEL classification: G21, G28, G34, M41.

Working paper no. 404