Managing Financial Reports of Commercial Banks

Anne Beatty, Sandra Chamberlain and Joseph Magliolo

Center for Financial Institutions Working Papers from Wharton School Center for Financial Institutions, University of Pennsylvania

Abstract: This paper investigates the extent to which banks alter the timing and magnitude of transactions such as asset sales, loan loss accruals, pension settlements and securities issues in response to primary capital, tax, and earnings goals. The authors hypothesize that each year bank managers face a cost minimization problem that encompasses the costs of deviating from primary capital, tax, and earnings goals, as well as the costs of exercising discretion over loan loss accruals, transactions such as asset sales, and securi-ties issues. The authors construct a system of five equations, one for the optimal level of each of the items over which the manager can exercise discretions to achieve the three goals.

The authors find that loan charge-offs, loan loss provisions, and the decision to issue securities are jointly determined, apparently to manage primary capital ratios. The research suggests that pension settlement gains are determined independently of the other four decisions, and appear to be used to manage end-of-period earnings.

Miscellaneous gains (losses) are used primarily to manage earnings; but weaker evidences suggests that they are also used to manage capital. The authors find broad support for the hypotheses that deviating from capital and earnings goals is costly, and that bank managers trade-off costly accrual and financing discretion to meet these goals.

The policy implications of this recent research are intriguing. For example, mark-to-market rules that limit the manager's ability to strategically time gains from sales of securities may simply induce the manager to substitute an alternative form of discretion - delaying or accelerating charge-offs and loan loss provisions. The framework and evidence support the notion that accrual, investment, and financing decisions are not independent. In the context of contracting and monitoring motivations for accounting choices, this means that focusing solely on the accounting systems's role in mitigating these costs potentially omits important correlated factors.

Date: 1993-08
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