Loan loss provisions and income smoothing – Do shareholders matter?

Abstract

In this paper, we aim to analyse the role of shareholders in the creation of discretionary loan loss provisions (LLP) and the use of LLP in income smoothing. Using a sample of over 200 Central European banks, we demonstrate that LLP and income smoothing of foreign-owned banks and state-owned banks differ from those of domestic private banks. Foreign and state banks create higher discretionary LLP than private domestic banks. Foreign banks use these LLP to perform discretionary income smoothing, while state banks, in general, do not smooth income. Higher LLP of foreign banks are observed in banks with low asset quality and high profitability. Foreign banks with low profitability that operate in volatile economic environments do not create higher discretionary LLP than domestic private banks. This implies that their risk is not lower than that of locally owned banks, at least on the credit side. In the aftermath of the financial crisis, both foreign and state banks have become more prudent than domestic private banks, and their discretionary LLP are higher. Overall, we provide evidence that foreign and government ownership affect LLP policy in banks. This complements existing results on the differences in loan cyclicality and default risk between foreign, state and domestic private banks.

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