Prisco, Martina (2023) Loan Loss Provisioning: Exploring Earnings Management practices in the Banking context. [Tesi di dottorato]

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Abstract

The quality of accounting information in the banking context is a key determinant for the stability of the global financial system and the economic growth. Furthermore, since banks are black boxes whose operations are hard to observe from outside, it is also fundamental to limit the sector opacity. In this regard, the occurrence of earnings management practices interferes negatively with the quality of provided accounting information, increasing the likelihood to mislead users. Based on this issue, academics have investigated possible opportunistic behaviours that may occur within the preparation of financial statements in the banking context. Being the largest discretionary accruals, empirical studies show that preparers manage earnings through the recognition of loan loss provisions. Following this stream of literature, this thesis explores some earnings management practices through loan loss provisioning in underexplored fields of research. The Chapter I aims to investigate whether bank preparers are encouraged to take a big bath during downturns. In order to achieve this objective, the time horizon of analysis includes three different crises that have significantly affected the banking context over the 2007-2021 period. They are the Global Financial Crisis, the Sovereign Debt Crisis and the Covid-19 pandemic. Based on a sample of 1,430 banks from United States and European Union countries, empirical evidence shows that preparers take a big bath during downturns by recognizing higher than necessary provisions in order to report a better future performance when the business cycle is positively inverted. The Chapter II aims to investigate whether bank preparers have enhanced the practices of income smoothing and capital management under IFRS 9 “Financial Instruments” that has replaced the previous IAS 39 “Financial Instruments: Recognition and Measurement” since 2018 annual reporting. Examining a sample of 131 banks from European Union countries over the 2015-2020 period, empirical evidence shows that preparers have strengthened these opportunistic behaviours under the new standard. This is explained in light of the forward-looking impairment required by IFRS 9 that has increased discretion in the recognition of loan loss provisions, thus offering new opportunities to manage earnings and capital compared to the previous backward-looking impairment under IAS 39. The Chapter III aims to investigate whether bank preparers have recognized higher income adjustments under IFRS 9 during the Covid-19 pandemic. Based on a sample of 176 banks from European Union countries over the 2016-2021 period, empirical evidence shows that preparers have recognized higher discretionary loan loss provisions during Covid-19 pandemic under IFRS 9 compared to previous reporting years, thus suggesting larger adjustments to reported income through the recognition of such accruals. In this regard, Covid-19 pandemic represented the first test of the new standard within a crisis scenario, increasing uncertainty to the extent that making reliable expected losses based on the forward-looking impairment was extremely difficult. Thus, preparers may have exploited such circumstance to enhance practices of earnings adjustment through loan loss provisions under IFRS 9. Taken together all the Chapters, this thesis extends previous banking literature on earnings management, showing empirical evidence about the discretionary use of loan loss provisioning during downturns, under IFRS 9 and within the adoption of this standard during the Covid-19 pandemic. In doing so, it also provides a better understanding and a clearer picture about some opportunistic behaviours through loan loss provisioning that occur within the preparation of financial statements in the banking context. They are the practices of big bath accounting, income smoothing, capital management, and, overall, income-increasing and income-decreasing adjustments. Finally, results emerging from the thesis as a whole are relevant for regulators, standard setters and investors that rely on financial statements and are interested in assessing the quality of accounting information in the banking context.

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