Income Smoothing Management and Loan Loss Provisions in the Banking System

Abstract

The "public interest" of financial institutions was used as an argument to intervene in accounting practices. The Bank of Spain's standard was not compatible with IAS 39 and the Spanish banking sector had become one of the most provisioned in Europe. This makes it an interesting case study of the relationship between provisioning and income smoothing. The 2008 financial crisis revealed that provisions were insufficient, and a reinforcement regulation process began in 2012. This paper aims to examine whether, since 2012, the Bank of Spain’s regulatory effort on impairment accounting standards has induced less income smoothing, correcting its counter-cyclical effect. A regression model is applied during the period 2005–2020, to test whether there is a trend change in the correlation between the level of provisions and annual earnings in 2012. The results show that from 2012 onwards (when the Bank of Spain reinforced the regulation on provisioning), there was a correction in income smoothing behaviour. This study provides empirical evidence that reinforces the claim that accounting policy can affect decision-making accounting practices, in this particular case, at the Bank of Spain.