Review of Quantitative Finance and Accounting, 20: 63–80, 2003
2003 Kluwer Academic Publishers. Manufactured in The Netherlands.
Managerial Incentives for Income Smoothing
Through Bank Loan Loss Provisions
Michael G. DeGroote School of Business, McMaster University, Hamilton, Ontario, Canada L8S 4M4
Tel.: (905) 525-9140, Fax: (905) 521-8995
GERALD J. LOBO
School of Management, Syracuse University, Syracuse, NY 13244-2130, U.S.A.
Tel.: (315) 443-3583, Fax: (315) 443-5457
School of Business and Economics, Wilfrid Laurier University, Waterloo, Ontario, Canada N2L 3C5
Tel.: (519) 884-0710, Fax: (519) 884-0210
Abstract. We examine alternative underlying motives of bank managers in using loan loss provisions (LLP) to
smooth reported income. Based on the analytical results of Fudenberg and Tirole (1995), we predict that for banks
with good (poor) current performance and expected poor (good) future performance, managers will save income
for (borrow income from) the future by reducing (increasing) current income through LLP. We also analyze three
additional variables that could explain cross-sectional differences in the level of income smoothing. Our empirical
analysis provides support for our predictions. The difference in LLP between the two groups of banks is positive
as hypothesized, indicating that bank managers do save earnings through LLP in good times and borrow earnings
using LLP in bad times. Similar results are obtained for analysis using discretionary LLP. When bank managers
are saving earnings for the future, we provide evidence that the need to obtain external ﬁnancing is an important
additional variable in explaining cross-sectional differences in the extent of income smoothing. Furthermore,
whether or not a bank is well capitalized is also weakly signiﬁcant in explaining cross-sectional differences in
Keywords: income smoothing, loan loss provision, job security
JEL Classiﬁcation: C23, G14, M41
This paper examines alternative motivations underlying bank managers’ use of their dis-
cretion over loan loss provisions (LLP) to smooth reported income.
LLP is generally the
largest accrual for most banks. Bank managers estimate LLP to reﬂect changes in expected
future loan losses.
This process allows them wide latitude for discretion in the estimation