The Expected Loan Loss Model and Earnings Management:

Evidence from Contemporary Practices

1
Marwa Elnahass
Newcastle University Business School, Newcastle, NE14SE, UK,

Marwan Izzeldin
Lancaster University Management School, Lancaster, UK LA14YX, UK

Gerald Steele
Lancaster University Management School, Lancaster, UK LA14YX

March, 2016

Abstract

This paper examines the discretionary use made by banks of loan loss provisions, in managing Basel
II regulatory capital ratios and in smoothing earnings. With the weak performance of the ‘incurred’
loan loss model during the financial crisis, our examination extends the debate on earnings
management practices with the future adoption of the ‘expected’ loan loss model. As Islamic banks
formed a legislative framework based on ‘expected’ losses in the loan portfolio, conventional banks
continued with the ‘incurred’ loan loss model. We find that the use by conventional banks of the
‘incurred’ model leads to significant opportunistic earnings management behaviour. We also note the
additional governance monitoring of Islamic banking in the context of the application of discretion
under the ‘expected’ loan loss model. The issues that we discuss invite further policy and regulatory
investigations after the scheduled implementation in 2018 of the IFRS 9 ’expected’ loan loss model.

Keywords: IFRS, Regulatory Capital management, Expected loan losses, Incurred loan losses.
JEL Classification: C23, G01, G21, G28, L50, M4

1
Corresponding author: Dr. Marwa Elnahas (Lecturer in Accounting & Finance), Newcastle University Business School,
Newcastle University, UK. Email: marwa.elnahas@newcastle.ac.uk.

1
Abbreviations: CBs: Conventional banks; IBs: Islamic banks; AAOIFI: Accounting and Auditing
Organization for Islamic Financial Institutions; LLP: Loan loss provisions; I-LLM: Incurred loan loss
model; E-LLM: Expected loan loss model; LLMs: loan loss models; SSB: Shariah Supervisory
Board.

1. Introduction

Maintaining adequate regulatory capital and promoting financial reporting quality are key
instruments of international banking regulation. The broad objective is to prevent opportunistic
earnings management2 and excessive risk-taking (Larson and Street, 2004; Abdelsalam and Weetman,
2003; Leventis et al., 2011; Manganaris et al, 2015). Established in 2001, the International Accounting
Standards Board (IASB) was instrumental in harmonizing international accountancy practice and in
improving the quality of financial reporting. Under the auspices of the IASB, over 8000 listed
companies in the 25 countries of the European Union saw the instigation of International Financial
Reporting Standards (IFRS).
Although based upon the ethos of the West, by their attraction to international investors and in the
absence of any comparable alternative, IFRS have been adopted worldwide. (Cieslewicz, 2014). For
example, by its general encouragement and provision of conditional loan grants, the World Bank has
furthered the adoption of IFRS. (Mir and Rahaman, 2005). Yet, IFRS practices have been questioned
(Baydoun and Willett, 1995; Outa, 2013), not least for ignoring the relevance of cultural constraints
and unique governance mechanisms in different parts of the world. (Abdelsalam and Weetman, 2003;
Nobes, 2006; Daske et al. 2008; Irvine, 2008; Cieslewicz, 2014)3.
Several emerging economies were early in adopting IFRS, where unique challenges relate to
different bank types. (Rathmell, 2000; Exell and Rico, 2013; Kanagaretnam et al., 2015). This is
particularly relevant to the distinctiveness of Islamic banking4, where the precepts of Shariah Law5

2
In line with Haley and Wahlen (1998), we define earnings management as the use of management’s judgment in financial
reporting and in structuring transactions where the objective is either to mislead stakeholders or to influence contractual
outcomes.

3
Cultural constraints involve religious and ethical dimensions (Kanagaretnam et al., 2015), which may be relevant to
financial outcomes. (Inglehart and Baker, 2000). Culture not only affects individuals’ conduct (Barro and McCleary, 2003),
it is regarded as an organisational factor affecting managerial, legal and educational systems, all of which influence
accounting practice. (Hofstede, 1980); and Gray, 1988)

4
Islamic banking holds $US 1.2 trillion of assets with estimated annual growth of 10-15%. (Ernst & Young, 2015b). Codes
regulating Islamic banking include non-financial measures such as economic, social, ethical and religion-related activities.
(Iqbal, 1997).
5
Shariah Law prohibits transactions involving interest and speculation.

2
invoke a unique business model, multi-layer governance and operational restrictions. Attempts to
cater for such considerations led to the formation of the Accounting and Auditing Organization for
Islamic Financial Institutions (AAOIFI)6 in 1990. More recently, by its close alignment with IFRS, it
has been argued that AAOIFI standards fall short in providing distinctive guidance to Islamic banks
(IBs) and their clientele. (Lewis, 2001; Maurer, 2002; El-Gamal, 2006). Furthermore, IFRS is
criticised for failing to acknowledge the institutional features of different bank types. In terms of
financial prudence, we present new evidence on how alternative IFRS Loan Loss Models (LLMs)7
that are used by different bank types are associated with the quality of earnings management and
financial reporting.
With the financial crisis of 2008, pressure grew to review financial reporting standards for loan
losses. In 2009, a proposal by the U.S. Treasury emphasised the need for a more forward-looking
model. (PwC, 2012; Ernst & Young, 2014a). In response, there was a joint meeting between the
Financial Accounting Standards Board (FASB)8 and the IASB. In November 2009, the IASB issued
an exposure draft which suggested revisions to the impairment methodology. This was followed in
May 2010, by a separate FASB exposure draft. Finally, at their December 2011 conference, the twin
FASB-IASB boards proposed a change from the ‘incurred’ to the ‘expected’ loan loss model.
The ‘incurred’ loan loss model (I-LLM) follows IAS 39 Financial Instruments: Recognition and
Measurement. The model is backward-looking in that it is triggered by past events before LLP is
created, making no allowance for accumulation during booms to ensure the resources necessary to
survive subsequent credit shocks. The more recent forward-looking model, as proposed under IFRS 9
Financial Instruments, is the ‘expected’ loan loss model (E-LLM). Under this model, the provision for
credit losses is made before a credit event occurs. (Ernst & Young, 2014a). Although the
implementation of the E-LLM by conventional banks (CBs) has been deferred until 2018,
provisioning decisions for IBs under AAOIFI have matched the structure of the E-LLM since at least
2010. (ACCA and KPMG, 2010; Sarea and Hanefah, 2013; AAOIFI, 2015). For countries adopting
AAOIFI, the implication is that the E-LLM is mandatory for IBs in Bahrain, Jordan, and Qatar.
(Zoubi and Al-Khazali, 2007; Taktak et al., 2010). Those countries are also characterized by having a
dual banking system, though with a relatively high concentration of IBs. (Pinner and Yan, 2015).
This situation has delivered a unique setting for examining banks applying two regulatory
frameworks: IFRS and AAOIFI. Irrespective of which regulatory framework is adopted, the

6
The AAOIFI applies accounting, auditing, ethical and governance standards to Islamic institutions. It is supported by nearly
200 members, which include central banks, across 40 countries. (AAOIFI, 2015).

7
A loan loss reserve reflects anticipated credit losses within a bank’s loan portfolio. Loan Loss Provision (LLP) is a flow of
funds (both positive and negative) that directly affects the content of financial reporting and the volatility and cyclicality of
bank earnings.

8
The Financial Accounting Standards Board (FASB) is a private, non-profit organization whose primary purpose is to
establish and improve generally accepted accounting principles within the USA.

3
promotion of financial reporting quality is a universal objective. (Leventis and Dimitropoulos, 2012).
The more opaque are financial reporting practices, the more banks are open to criticism for agency
problems9 that arise from the separation of ownership and control. It is in that context that managers
may seek personal advantages to the detriment of shareholder value. That banks might deliberately
engage in discretionary practices to manage regulatory capital ratios and to report fictitious earnings
are obvious impediments to financial stability. There lies the rationale for strict capital adequacy 10
regulations like the Basel II Accord.
Regulators require bank managers to estimate LLP so as to reflect changes in expected loan losses,
leaving unexpected losses to be absorbed by bank capital. (Fonseca and Gonza´lez, 2008). Whether by
the E-LLM or the I-LLM, reported LLP are subject to managerial judgments both in regard to timing
and to magnitude. (see Beaver and Engle, 1996; Dermine and Carvalho, 2008; Berger et al. 2008;
Elnahass et al. 2014). Given the prohibitive expense for investors to obtain information relevant to the
loan portfolio and related default risk (Wahlen, 1994), LLP offers a temptation for managers to act
opportunistically. Even in highly regulated reporting systems, the discretionary power remains for
managers to send distorted signals to stakeholders, so hiding the substance of a bank’s activity.
Agency costs are clearly relevant in regard to LLP11 by IBs12 and CBs under the Basel II regulatory
capital ratios.
Concerns relating to opportunistic earnings management and inadequate disclosure of LLP have driven
bank regulators to focus on capital adequacy and the relevance of LLMs. While the I-LLM has been
criticised for giving a pro-cyclical13 bias to lending, the greater sophistication of valuations under the E-
LLM, may carry an enhance potential for the opportunistic management of capital adequacy ratios. Among
criticisms of the E-LLM are that: (i) reliance on management judgement to estimate future cash flows may
detract from the reliability of reported financial information (Wezel, 2010; Ernst & Young, 2014a); (ii) the
model is less transparent than the I-LLM, to the extent that it permits the concealment of a deteriorating
loan portfolio (Federation of European Accountants, 2009); and,

9
‘Agency costs’ refer to the monitoring this is undertaken to reduce conflicts of interest between the principle and the agent.
(Jensen and Meckling, 1976; and Jensen, 2005).

10
A capital adequacy ratio indicates the capital that a bank must hold. It is expressed as a percentage of a bank’s total risk
weighted assets. (Ariss and Sarieddine, 2007).

11
Among a variety of motives for ‘managing’ Basel capital ratios are: to raise a bank’s performance as perceived by
stakeholders; to influence contractual outcomes (Healy and Wahlen, 1999; Burgstahler et al., 2006); to cover financial
losses; and to meet financial targets (Dermine and Carvalho, 2008; Berger et al., 2008).

12
IBs also follow Basel requirements as part of the ‘Capital Adequacy Standard’ issued by the IFSB. This was mandatorily
adopted in 2006. (IFSB, 2005; Ariss and Sarieddine, 2007).

13
Pro-cyclicality implies that loan portfolios expand in a boom, with no commensurate increase in total capital provision.
Then, in a cyclical downturn, LLP is in arrears. Banks then curtail lending, so increasing pro-cyclicality (Koopman et al.
2005; Jokipii and Milne, 2008).

4
(iii) the model allows considerable discretion in smoothing earnings which may detract from
transparency and increase risk-taking (Bushman and Williams, 2012).
Although IBs address liquidity risk by maintaining high liquidity buffers, constraints upon trading
in certain types of financial instruments limit the access of IBs to external markets. That IBs do not
compete on an equal footing with CBs (Hasan and Dridi, 2010) might give an incentive to use LLP for
opportunistic capital management. Telling against that consideration is the ethical commitment of IBs
to their stakeholders, which is likely to enhance financial reporting quality. (Choi and Pae, 2011).
Earnings management practice by IBs is also subject to an additional governance mechanism: the
Shariah Supervisory Boards (SSBs)14.
More generally, the core issue is the impact on earnings management practices of the current/future
adoption of the E-LLM by IBs and CBs. Is the potential for accounting opportunism under the E-LLM
more likely to be tempered by IBs than by CBs? In attempting to address these and related issues, our
paper is the first to invoke empirical evidence on aspects of the two LLMs in countries where there is
different treatment for loan losses by different bank types.
Our analysis uses panel data comprising 441 bank-year observations (63 banks) over the period
2007-2013. That period is likely to expose the relevance of the Capital Adequacy Standard under
Basel II, which became effective for mandatory implementation by IBs in 2007. (IFSB, 2005; Ariss
and Sarieddine, 2007). There is some evidence from the assessment of regulatory capital management
both during and after the 2007 financial crisis that, when they are in financial distress, banks are less
diligent in meeting regulatory requirements. (Hoffmann and Pennings, 2013). To address that feature,
we use the lagged Tier 1 capital ratio15 to examine regulatory capital management through LLP by
IBs and CBs.
Consistent with expectations we find that banks located in emerging economies, on average, tend
to use LLP to discretionary manage Basel capital ratios, possibly to avoid regulatory penalties. We
also note the significant impact of the bank type on earnings management practices. In the application
of the E-LLM by IBs, we find no evidence of opportunistic management, either by regulatory capital
management or the smoothing of earnings through LLP. This does not necessarily mean that the E-
LLM deters discretionary acts. Rather, we note the relevance of the added layer of governance
through SSBs and/or the scrutiny of investors/depositors in monitoring the reporting practices of IBs.
For CBs applying the I-LLM, we find significant evidence of the discretionary use of LLP to manage
Tier 1 and to smooth reported earnings. We also find that the application of the I-LLM accentuates the

14
The SSB operates as an internal audit unit or internal control mechanism with the primary objective of giving credibility
to the operation of IBs. (Haniffa and Hudaib, 2007). Members of the SSB must be specialists in Islamic jurisprudence. Their
main duties are: (i) to introduce Shariah rules for the conduct of banking business; (ii) to indicate breaches of Shariah rules;
and (iii) to issue a statement of ‘assurance’ in the annual report of IBs. (Malkawi, 2013).

15
As an equity measure of capital, Tier 1 capital (‘core capital’) is the sum of equity book value, qualifying non-cumulative
perpetual preferred stock and minority interests in equity accounts of subsidiaries, less goodwill and other intangible assets.
Under Basel II, IBs and CBs must maintain a minimum ratio of 4% of Tier 1 capital and 8% of total capital. (IFSB, 2005).

5
impact of pro-cyclical lending, so raising the likelihood of financial distress. (Federation of European
Accountants, 2009; Wezel, 2010; Bushman and Williams, 2012). However, we offer no evidence that
the E-LLM mitigated pro-cyclical effects during the recent financial crisis.
This study contributes to the extant literature in a number of ways. In providing evidence for the
influence of bank type on earnings management practices, the paper highlights the extent to which the
discretionary use of LLP might differ between conventional and Islamic banking systems. In that
aspect, our paper extends prior studies on the relation between accounting discretion and the impact of
the cultural/religion orientation of banking (see McGuire et al., 2012; Dyreng et al., 2012; Elnahass et
al, 2014; Kanagaretnam et al., 2015). Second, we gain insights on the important distinction between
the structures of the two LLMs that are used for LLP. This adds to earlier work relating to accounting
for impairments (see Zoubi and Al-khazali, 2007; Federation of European Accountants, 2009; Wezel,
2010; Leventis et al., 2011; Bushman and Williams, 2012). Finally, to the best of our knowledge, this
is the first study to examine earnings management practices under the E-LLM by providing an
illustrative empirical test through set of banks currently adopting this model.
Our study: (i) informs regulators, investors, bankers and auditors on financial reporting quality and
accounting discretion; (ii) delivers insights on the relevance of bank type and structural differences in
LLM; (iii) has relevance to recent regulatory attempts under Basel III to align LLP with a counter-
cyclical approach16. Under the new Basel III, banks will be able to use the E-LLM model to drive
minimum regulatory capital requirements. Our findings suggest that the IASB should review their
objectives in setting regulatory capital adequacy requirements, taking account both of the treatment of
loan loss and the relevance of institutional factors.
The paper has 8 sections of which this is the first. Section 2 examines the treatment of LLP under
IFRS. Section 3 sets our hypotheses in respect of regulatory capital management. Section 4 outlines
the data and methodology. Section 5 presents our descriptive and empirical results. Section 6
describes our robustness checks. Section 7 concludes.

2. Loan Loss Provisions under IFRS

Accounting for loan losses follows one of two models: one for ‘expected’ and the other for
‘incurred’ loan losses. IAS 39 was first issued in March 1999, since when there have been a number
of limited revisions. (Ernst & Young, 2011). The definition of ‘incurred losses’ is the impairment of a

16
Basel III is a response to perceived deficiencies in capital regulations as accentuated during the financial crisis of 2009.
Effective for final implementation in 2018, Basel III aims to provide global regulatory standards for bank capital adequacy
and liquidity, including a counter-cyclical capital buffer. The latter is designed to ensure that capital requirements take
account of the macro-financial environment. Its primary objective is for a capital buffer to protect the sector from periods of
excessive credit growth that can be associated with system-wide credit risk. That approach is consistent with the E-LLM
which invites the use of a counter-cyclical capital buffer.

6
financial asset or a group of financial assets based on objective evidence of impairment showing a
‘loss event’ after the initial recognition of the asset. A loss event (or events) must have an impact upon
future cash flows of a financial asset or group of assets that can be reliably estimated. (Ernst &
Young, 2011). Each loan is individually valued to determine whether a loss event has taken place,
where the assessment is made at the end of each reporting period. Therefore, LLP requires a loss
impairment event to occur before the financial reporting date. Criticisms of the I-LLM cite this as a
main cause of the severity of the 2007-2009 financial crisis (Balla and McKenna, 2009; Wezel et al.,
2012). Other studies similarly criticize the I-LLM for accentuating pro-cyclical effects. (Bikker and
Metzemakers, 2005; Fillat and Montoriol-Garriga, 2010; Wezel, 2010; Bouvatier and Lepetit, 2012).
As a counter-claim, proponents of the I-LLM claim that it is effective in mitigating opportunistic
earnings management. (Federation of European Accountants, 2009; Wezel, 2010; Bushman and
Williams, 2012).
The E-LLM relies upon banks building incremental provisions for the ensuing 12 months. LLP is
practiced during good times to absorb potential credit losses during economic downturns. For the
calculation of expected losses, the E-LLM requires the identification of an effective interest rate
component at the inception of the loan. (Wezel, 2010; Federation of European Accountants, 2010).
This is expected to improve the usefulness and relevance of financial reporting for stakeholders.
(Wezel, 2012; Bouvatier and Lepetit, 2012).
The E-LLM implies, not only that larger LLP will have to be made, but that LLP will vary in line
with changing assessments of credit and default risks. Additional forecasting will become necessary
for the whole portfolio of financial assets, measured at amortised cost. During the period of transition
to the implementation of the E-LLM, profits will be reduced for the first-implementation year. (Ernst
& Young, 2014a). In addition, the transition period will require more complex auditing processes and
verification procedures (e.g., accuracy, valuations, completeness and occurrence assertions) for
expected credit losses.
The main distinction between the two models lies with the timing rather than the level of loan
losses, where the I-LLM shows relatively higher net income in the period immediately following the
acquisition of an asset, the E-LLM shows relatively lower net income in the early period of an asset’s
life. One of the goals in this paper is to investigate some of the underlying characteristics of the two
LLMs by observing their impact on banks’ regulatory capital management.
Our data for sample countries (Bahrain, Jordan, and Qatar) uniquely represent an environment
where IBs and CBs operate under the respective auspices of AAOIFI and IFRS. Under the AAOIFI
Financial Accounting Standard (FAS 11), IBs are required to have adequate provision for asset
impairment and credit risk exposure:
‘A provision shall be recognized when information becomes available to the Islamic bank
indicating that an event resulting in or that will probably result in, the impairment of the value of
assets.’ (AAOIFI, 2010, Paragraph 6: p.332).

7
Thereby LLP is decided on the basis of the expectation of potential loss resulting from an unspecified
risk. Effectively, therefore, this is equivalent to the E-LLM:
‘Under the expected loss model, no loss event is required and therefore changes in economic
conditions on their own lead to changes in estimates which are recognised as gains and losses. …
Banks are required to estimate the losses they expect to incur on the loan assets….and reduce loan
assets by such amounts for regulatory capital purposes.’ (Federation of European Accountants,
2010: p.10).

In complying with AAOIFI, FAS 11 requires IBs to use the ‘expected’ rather than the ‘incurred’
approach. This practice was confirmed by our review of forty-nine hand-collected annual reports for
our IBs subsample. In every case managers were using the E-LLM:
‘Conventional and Islamic banks differ substantially in terms of their provisioning policy. The
AAOIFI encourages Islamic banks to adopt dynamic provisioning which allows them to better
anticipate credit risk….. This consists of setting aside provisions for loans based on expected
rather than actual or realized losses.’ (Taktak et al., 2010, p. 116).

The adoption of the E-LLM by FAS 11 provides an opportunity to assess the impact on the earnings
management practices of IBs. However, that opportunity can only be fully exploited if those practices
are compared with the I-LLM used by CBs. In the next section we discuss the regulatory capital
hypotheses and their influence on financial reporting quality in both bank types.

3. The Regulatory Capital Management Hypotheses

Earnings management refers to accounting opportunism in reported financial information and there
are several techniques to its application. According to Wahlen (1994) and Healy and Wahlen (1999),
managers can discretionarily affect accounting choices through exploiting flexibility in accounting
principles, violating exiting accounting standards and/or managing earnings through reported
transactions. One of the most important accruals used to directly exercise earnings management is
LLP (Collins et al., 1995). Bank managers are well informed regarding the default risk inherent in
their loan portfolios. Therefore, their judgment is crucial in estimating the LLP each reporting period.
(Wahlen, 1994). Managers can unusually manage earnings positively or negatively through the flow
of LLP in the income statement to either overstate or understate a loan loss reserve.
Under the capital management hypothesis, higher LLP could be discretionarily reported by
managers when total capital is low to avoid regulatory capital penalties and/or to meet expected
losses. (Gambacorta and Mistrulli, 2004; Dermine and De Carvalho, 2008). This would provide banks
with two substitutable buffers. Financial reporting standards are potentially undermined where banks
have general incentives to opportunistically adjust accounting reports. (Wall and Koch, 2000;
Burgstahler et al., 2006; Barth et al. 2008; Leventis et al., 2011). This is more likely under the capital

8
allocation feature of LLP reported within the Basel II framework and particularly when it is expensive
to access market sources to raise capital.
Mixed evidence is documented by previous studies on the opportunistic use of LLP in CBs for
regulatory capital management. Moyer (1990) finds that bank managers adjust the discretionary
component of LLP in order to reduce regulatory costs. Beatty et al. (1995) conclude that loan charge-
offs and LLP are both used as mechanisms of capital management. Lobo and Yang (2001) test
multiple managerial motivations for discretionary LLP: signalling, income-smoothing and capital
management. They find that managers discretionarily manipulate LLP downward to meet regulatory
capital requirements. Collins et al. (1995) find no significant association between LLP and regulatory
capital management. Their results show that banks used write-offs more than LLP to manage capital
ratios. Ahmed et al. (1999) show that capital management is an important determinant of LLP.
Ismail and Be Lay (2002) show that Malaysian IBs used LLP to manage earnings in the period
1997-1999. For a sample of only ten Malaysian banks offering Islamic banking services, Ismail et al.
(2005) show that managers used realized security gains/losses, instead of LLP, to manage earnings.
Taktak et al. (2010) find no such evidence for IBs. For both bank types, within the GCC region, Zoubi
and Al-khazali (2007) show that both IBs and CBs use LLP to smooth income. Elnahass et al. (2014)
report that: the pricing of LLP influences investment decisions; and that the discretionary element of
LLP can be used to raise bank value in capital markets of both bank types.
The above studies are inconclusive in their findings of the extent to which (if any) earnings
management takes place in IBs; and none distinguishes between the adopted regulatory framework
(i.e., IFRS and AAOIFI) and the nature of the LLMs adopted. This is clearly important in identifying
motives and underlying opportunities for earnings management practices, especially under changing
market conditions where LLMs operate differently.
We first develop a general hypothesis for both bank types that managing regulatory capital ratios is
expected under the Basel II framework. Both IBs and CBs would need to use their own judgement to
incorporate data into the provisioning loss model. As banks deduct from its capital base any shortfall
in LLP arising from loan losses, excess reserves are likely to be positively associated with regulatory
capital management. This is consistent with the views of Wahlen (1994) and Healy and Wahlen
(1999) for managing earnings through real transactions. Therefore, irrespective of which LLM is
applied, our a priori reasoning is that banks first ensure affordability with a sufficient (Tier 1) buffer
in the year preceding the reporting year of LLP. (Bushman and Williams, 2012). We conjecture that
banks with sufficient Tier 1 capital in the preceding year can avoid regulatory penalties by increasing
LLP in the current year, while controlling for any negative effect on their regulatory total capital ratio.
This leads to the formulation of our first hypothesis:
01: For both IBs and CBs there is a positive association between LLP and lagged Tier 1 ratio.

9
 Distinguishing between the two bank types and the structure of the LLMs applied, an E-LLM has a
profit smoothing property (Wezel, 2010). According to the Federation of European Accountants
(2009), the I-LLM necessarily involves subjective estimates of future cash flows which can be
discretionarily used by bankers; but that discretion is to a lesser extent than that under the E-LLM.
Although the E-LLM is used by IBs, additional institutional factors suggest some mitigation for
managing regulatory capital ratios through LLP. The ethical commitment of Islamic banking is likely
to constrain excessive risk-taking. (Belal et al., 2014). According to Choi and Pae (2011) companies
with a substantial level of ethical commitment show a higher quality of financial reporting and less
involvement in earnings management. In principle, IB managers must not operate in a manner that
misleads stakeholders. (Beekun and Badawi, 2005). Our prediction is that banks governed by strict
ethical codes are more conservative in their reported earnings (Hilary and Hu, 2009; Kanagaretnam et
al. 2015) and are less likely to engage in opportunistic or fraudulent accounting (see Ahmad, 2000;
Dyreng et al., 2012; McGuire et al., 2012).
That opportunistic management of regulatory Tier 1 is not Shariah compliant may also cause IBs to
undertake less risky operations and to shun opportunistic management practices. The governance
monitoring by SSBs act as an internal audit mechanism to screen non Shariah-compliant transactions.
Furthermore, IB depositors (investment account holders) share in the bank’s profits and losses based
on predetermined proportions for equity-based contracts. Investment losses are completely borne by
those depositors unless they are the consequence of misconduct on the part of the bank. (Belal et al.,
2015). That IBs do not empower depositors or investors to directly monitor their investment through
representation on the board of directors, gives rise to additional agency costs and increases the risk of
managerial opportunism (Abdel Karim and Archer, 2002). Therefore, investors and depositors in IBs
have an enhance motive to scrutinize their investment portfolios. This provides additional monitoring
of IBs.
Based on the above, we conjecture that opportunistic capital management through LLP is less
likely in IBs than CBs using. This leads the formation of the second hypothesis:
02: The positive association between LLP and lagged Tier 1 ratio is lower for IBs than CBs.

4. Data and Methodology

Data sources include Thomson One Reuters, Bankscope and Zawya databases. The sample consists
of 441 bank-year observations (63 banks) including listed and unlisted banks operating in Bahrain,
Jordan, and Qatar in the period 2007-2013. These countries are unique in that both IBs and CBs co-
exist but under different regulatory frameworks. They also have a homogeneous cultural and
macroeconomic environment. (Ernst & Young, 2014b; Kammer et al., 2015). To include as many
bank observations as possible, we use unbalanced panel data and allow for at least two time series
observations for each bank and a minimum of four banks within one particular country (Beck et al.,

10
2013). This leaves us with 34 CBs (238 bank-year observations) and 29 IBs (203 bank-year
observations). Table 1 reports the distributions of banks by type and country.

[Insert Table 1 here]

To examine 01 and 02, we estimate the regression specification outlined in Greenawalt and

Sinkey (1988) and Laeven and Majnoni (2003) as follows17:

∆ ∆
,
= +1 + ,
+ ,
+ + + +
, −1
0 1 2 3 4 5 6 ,

, −1 , −1 , −1

+ ++ + ∑
2013 + + (1)
7 , 8 , 9 , 10 ,, 11 =2007 12

Where the scripts i, j, and t denote the cross sectional dimensions for banks, countries and time respectively. LLP is the
loan loss provision. Tier 1 is a direct measure to test the capital management hypothesis. Under Basel II, the use of total
capital could lead to spurious inferences from: (i) the presence of Tier 2 capital as a component of the total capital ratio; and
18
(ii) the net tax effect of increasing Tier 1 and Tier 2 ratios . ∆NPL19 is the change in non-performing loans. ∆LOANs is
change in total loans. IBi is a bank type dummy variable (unity for IBs; zero for CBs). Crisist is a time dummy (unity for
2007-2009 IBs; zero otherwise). LEV is Leverage ratio (total debt to total common equity). GDP is the country-prevailing
GDP growth rate. INF is the country-prevailing inflation rate. CG is a set of country-specific governance indicators.
For 01, we predict that 1 is positive, where a significant relationship would imply that banks with a higher Tier 1 ratio in the preceding period tend to manage
regulatory capital through increasing LLP in the current period. For 02, we expect 1 to be lower for IBs (using the E-LLM) than for CBs (using the I-LLM); i.e., the IB
business model is more restrictive and subject to additional monitoring.

Earlier studies control for the current level and the dynamics of losses within the loan portfolio by using a proxy for the
non-discretionary component of LLP (e.g., Moyer, 1990; Ahmed et al., 1999; Jacques, 2010; Elnahass, 2014). In similar
vein, we apply a control using both the change in non-performing loans (∆NPL) and the change in total loans (∆LOANs). We
use the former as a proxy for

17
The Hausman test reported the presence of systematic differences between the fixed and random effects (chi square =
19.18). Results are robust when employing the Generalized Method of Moments (GMM) for the full study sample. However,
using fixed-effects allows more bank-year observations and control for heterogeneity across banks (Laeven and Majnoni,
2003; Fonseca and Gonza´lez, 2008).

18
Before the amendment of the Basel Accord (1988), the regulatory capital ratio was expected to be negatively related to
LLP; i.e., banks with low regulatory capital requirements had incentives to raise LLP (Ahmed et al., 1999). These incentives
are related to tax savings. The new situation under Basel II is that LLP must be included as a component of Tier 2 capital. An
increase in LLP has conflicting effects on Tier 1 and Tier 2 capital; and it could increase the level of total capital. On one
hand, higher LLP reduces Tier 1 capital through a reduction in retained earnings. On the other hand, in raising loan loss
reserves, an increase in LLP raises Tier 2 capital. Indeed, the increase in Tier 2 capital might be larger than the decrease in
Tier 1 capital due to tax advantages. (Lobo and Yang, 2001; Shrieves and Dahl, 2003).

19
Non-performing loans are those overdue by more than 90 days. They are disclosed as “supplemental financial statement
information” (Wahlen, 1994).

11
default risk, and the latter to control for changes in bank lending. (Lobo and Yang, 2001). We expect
both variables to have positive coefficients as LLP are accruals that reflect the evaluation of future
loan losses and higher non-performing loans. An increase in the outstanding total loan level should
increase the relative magnitude and timeliness of LLP. (Greenawalt and Sinkey, 1988; Fonseca and
Gonza´lez, 2008). We define the listing status of banks in line with evidence for the association
between a publically-traded firm and accounting manipulations. (Beatty and Harris, 1999; Fonseca
and Gonza´lez, 2008). The leverage ratio (LEV) is used to offsets a bank’s potential capital saving by
understating risks. (Leventis et al., 2011; Kiema and Jokivuolle, 2014). Leverage levels are expected
to be positive for both bank types, but relatively lower for IBs. This is justified by the absence, in
Islamic banking, of interest payments and non-trading in activities involving speculation/derivatives.
GDP captures pro-cyclicality in LLP as well as changes in inflation and the macroeconomic
environment. That inflation has a greater adverse effect on IBs is argued by their dependence on cash
reserves and their use of commodities as collateral (see, Valckx, 2003). Here, there is support from
Cavallo and Majnoni (2001) and Laeven and Majnoni (2003), who find negative relationships
between LLP, GDP growth and inflation: banks expand their loan portfolios in booms without
building up their total capital through provisioning. We predict loan losses to increase in response to
negative changes in GDP. Country governance indicators such as the rule of law (ROL) and
regulatory quality (RQ) are used. These variables indicate the strength of enforcement mechanisms
and legal systems.(Djankov et al., 2007). We predict a negative association between LLP and the
country governance indicators; i.e., banks are more likely to exercise discretion over the use LLP
where enforcement rules and regulatory governance are weak. (Fang et al. 2014).
To control for heteroscedasticity and endogeneity, all time series variables are normalized using total bank assets ( , −1) at the beginning of year . (Easton 2003; and
Barth and Kallapur, 1996). year dummies are intended to capture unobserved bank-invariant time effects. We also control for bank-specific effects ( ) but not for country-
specific effects.

[Insert Table 2 here]

5. Descriptive Statistics and Regression Results

In Table 3, panels A, B, and C report descriptive statistics for the full sample and sub-samples (IBs
and CBs). Banks in the sample countries report a mean LLP of 8.5%, with similar reported means for
IBs (8%) and CBs (8.7%). The regulatory capital management measure (Tier 1 ratio) indicates that
both bank types are adequately capitalized with a mean of 31.3% for IBs and 18.3% for CB. This is
indicative of the incentive for both bank types is to keep their core capital ratio (Tier 1 ratio) above the
4% threshold, in order to avoid regulatory penalties. According to Berger et al. (2008), Basel II
procedures deliver discretionary benefits to ‘well-capitalized’ banks that hold Tier 1 capital of at least

12
6% of RWA. In summary, Table 3 show that IBs are better capitalized, smaller in size and less
leveraged than CBs.
Table 4 presents the Pearson (Spearman) correlation coefficients above (below) the diagonal for the full sample. Consistent with our
expectation, both correlation indicators for the Tier 1t−1 ratio are significantly positively correlated with LLP. There are also statistically
significant correlations between LLP and our control variables (∆ ,;∆ , ; , ; , ; , ; , ; , ). Correlations among independent variables are
within accepted limits and raise no concerns with respect to multicollinearity.

[Insert Tables 3 & 4 here]

Table 5 reports tests of the regulatory capital management hypotheses ( 01) and ( 02) for the full sample based on two variants of equation 1. Variant (1) tests 01 irrespective of bank type. Variant (2)
tests 02 using the I-LLM (for CBs) and E-LLM (for IBs).

For variant (1), the significant and positive association between 1 , −1 and LLP is consistent with our expectations
and prior literature on the use of LLP to manage regulatory capital 20. This suggest that banks in these emerging
economies, on average, tend to use LLP to discretionary manage Basel capital ratios to avoid regulatory penalties. A
positive and significant coefficient for ∆NPL indicates an increase in LLP due to a rise in default risk and a relative
change in the quality of loan portfolios. A positive and significant coefficient for ∆LOANS indicates an increased use
of LLP during episodes of credit growth. The negative and significant coefficients for GDP indicate pro-cyclicality for
LLP is in line with predictions. Results show insignificant associations between LLP and both ROL and RQ, which
suggest that weaker enforcement laws do not necessary contribute to the discretionary use of LLP. Accordingly, we
argue that either the type of bank, or the structure of the LLM used, or both, explain this regulatory capital
management pattern.
In examining (Table 5) whether bank type affects the discretionary use of LLP under different LLMs ( 02), with variant (2) we find a consistently positive
and significant coefficient between LLP and 1 , −1. A significant coefficient on indicates the influence of the bank type on the level of LLP. In testing the
regulatory capital management incentive for IBs (using E-LLM) as compared to CBs (using I-LLM), we find insignificant association between the interaction
dummy (IBi ∗ Tier 1i,t−1) and LLP. This finding is consistent with our predictions and show that IBs do not appear to manage Basel capital ratio when reporting
under the E-LLM.
Table 6 presents additional tests for 02 within each individual bank type subsample. For IBs, insignificant coefficients for Tier 1t−1, indicate that
there is no discretionary use of the E-LLM to manage capital ratios. For CBs, we find a positive and significant association between LLP and

20
For sensitivity checks, we estimated the same model through fixed-effects using contemporaneous analyses of Tier 1 ratio
at time t for the full sample. Results are robust.

13
Tier 1t−1, suggesting discretionary use of the I-LLM to manage capital ratios. A negative and significant
coefficient for GDP for both bank types indicates a pro-cyclicality effect for LLP. The coefficient for the
GDP is higher for CBs, which is consistent with the notion that the I-LLM accentuates pro-cyclicality; but
for IBs the significant coefficient is counter-intuitive. This indicates that the E-LLM minimizes rather than
mitigates pro-cyclical lending. In controlling for the financial crisis, we find a highly significant positive
impact of the financial crisis for CBs and a marginal impact for IBs21. This is in line with prior evidence
(Beck et al., 2013; Pinner and Yan, 2015).
Overall, our results support the two regulatory capital management hypotheses, ( 01) and ( 02).
Banks appear to discretionarily manage regulatory capital through LLP. The analysis shows no such
evidence for earnings management by IBs using the E-LLM. This does not necessarily mean that the
E-LLM deters discretionary acts. Rather, it might be the effect of cultural inhibitions and the extra
layer of SSB governance. These results are in line with prior evidence on the impact of culture on the
use of accounting discretion and risk-taking behaviour. (Hilary and Hu, 2009; McGuire et al., 2012;
Dyreng et al., 2012; Elnahass et al, 2014; Kanagaretnam et al. 2015).

[Insert Tables 5 & 6 here]

6. Income-Smoothing

Shrieves and Dahl (2003) report a positive association for CBs between income and the
discretionary timing and magnitude of LLP. Other studies that document the widespread use of
income smoothing in LLP include Wahlen (1994), Laeven and Majnoni (2003), and Fonseca and
Gonza´lez (2008). Income smoothing can have a significant impact on capital adequacy. Archer and
Abdel Karim (2012) argue that the treatment of profit and sharing investment accounts in
conventional deposits provides a strong incentive for IBs to smooth their pay-out of profits. Taktak
(2011) suggests that this is a well-established IB practice.
As additional tests for the main results obtained under equation (1), we control for the incentive for income smoothing. We achieve this by adding a dummy
variable (LOSSit), (a dummy if a bank generates negative/zero earnings; zero for positive earnings). This dummy variable is interacted with Tier 1i,t−1, to test
whether discretionary capital management is intensified for low-earning banks. We conjecture that banks with low/negative earnings are more likely to practice
income smoothing. For additional testing of ( 01) and ( 02), equation (2) is specified as follows:

21
We conducted additional sensitivity tests for both ( 01) and ( 02) after controlling for bank ownership (we used two dummy indicators “whether the bank is government or private and whether it is a foreign or non-foreign
bank”. Our threshold was set at 25% of ownership. Untabulated analyses show the robustness of our results under both hypotheses.

14
 , = + + 1 + ∆ , +∆ , ++
0 1 2 ,
, −1 3 4 5

, −1 , −1 , −1

6+ 7 , +8 , +9 , 10 , + 11 , , +

∑2013 + + (2)
12 =2007 13

In testing ( 01) for the full sample, Table 7 shows the coefficient on , 1 , −1 to be positive and significant:
banks manage regulatory capital through LLP to smooth income when they are generating losses. In examining
( 02) for each subsample, IBs show insignificant associations between LLP and , 1 , −1, which suggests that
IBs do not consistently smooth earnings under E-LLM even when they are reporting losses. The results are in
line with our predictions indicating that IBs are less likely to engage in earnings management. For CBs, there is
a significant and positive association. These results suggest that I-LLM allows CBs to substantially smooth
income using LLP when they are pressurized by loss generation. Overall our principal results are consistent and
robust.

[Insert Table 7 here]

7. Conclusion

Within a set of Middle Eastern countries, where conventional and Islamic banking co-exist, we examine
the impact of the discretionary use of LLP under alternative LLMs. We also test the influence of bank type
in mitigating accounting opportunism, which is more likely to occur under the E-LLM.
Our results indicate that banks located in our sample of emerging economies, generally use LLP to
discretionary manage Basel capital ratios. The practice is more evident when banks face losses and
become more active in smoothing earnings. The bank type has a significant impact on the
discretionary use of LLP. In particular, the application of the E-LLM by IBs provides no evidence of
opportunistic management of regulatory capital even when losses are reported. We note that this does
not necessarily mean that the E-LLM deters incentives/opportunities for discretionary acts. We argue
for the relevance to IBs of the additional internal governance mechanism of the Shariah Supervisory
Board. In addition, monitoring by stakeholders may have contributed towards the mitigation of
earnings management practices.
For CBs applying the I-LLM, we find significant and strong evidence for the discretionary use of
LLP to manage Tier 1 ratios and to smooth reported earnings. Our findings also suggests that the I-
LLM accentuates credit shocks; and that the E-LLM is associated with pro-cyclical lending. By
implication, the E-LLM appears not to meet the intended purpose of mitigating exogenous shocks.
Overall, our results show the impact of bank type and the structure of LLMs in banking studies of
earnings management and impairments. Our findings are relevant to local and international regulators
as well as to bank stakeholders. We suggest that the more sophisticated E-LLM remains to prove

15
itself, not least in respect of regulatory structures in emerging economies; and that the relevance of
IFRS is less obvious for IBs than for CBs.
The implementation of the E-LLM should not be allowed to provide a false sense of confidence.
The degree to which our findings can be attributed respectively to the different characteristics of CBs
and IBs, or to the different criteria of the I-LLM and the E-LLM, remains unresolved. In both aspects,
there is some distance to travel before any confident claim can be made about the quality of financial
reporting. It would be instructive to review our approach after a few years’ experience, once the ‘E-
LLM becomes mandatory for CBs.
Acknowledgement:

We express our gratitude to the participants of the European Accounting Association Conference at
Dauphine University Paris; the NWDTC conference at Lancaster University; the 3th Islamic Banking
and Finance Conference at Aston University for providing us with some valuable suggestions

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Wahlen, J. (1994). ‘The nature of information in commercial bank loan loss disclosures’, Accounting
Review 69, 455–478.
Wall, L. D., & Koch, T. W. (2000). Bank loan loss accounting: A review of theoretical and empirical
evidence. Federal Reserve Bank of Atlanta Economic Review, Q2, 1–20.
Wezel, T. (2010). Dynamic Loan Loss Provisions in Uruguay: Properties, Shock Absorption Capacity
and Simulations Using Alternative Formulas. Working Chapter, Washington: International
Monetary Fund (IMF): WP/10/125.

20
_________., Chan-Lau J. A. & Francesc, C. (2012). Dynamic Loan Loss Provisioning: Simulations on
Effectiveness and Guide to Implementation. Working Chapter, Washington: International
Monetary Fund (IMF): WP/12/110.
Zoubi, T. A. & Al-Khazali, O. (2007). Empirical testing of the loss provisions of banks in the
GCC Region. Managerial Finance, 33 (7), 200-511.

Table 1 Sample Distributions of Banks by Country and Type

Country Islamic Conventional Total Composition Composition
Banks Banks IBs CBs
Bahrain 154 91 245 67% 38%
Jordan 21 105 126 9% 44%
Qatar 28 42 70 12% 18%
Observations 230 238 441 52% 54%
Banks 29 34 63 - -
Notes: The table shows the number of the Islamic banks and the conventional banks available in
Bankscope for each of the three countries during the sample coverage period of 2007 to 2013.
Composition (%) is the number of banks included in the sample as a percentage of the total
number of banks type observations.

21
22
 Table 2 Variable Definitions and Descriptions
Variable Notation Description
Loan Loss Provisions , Loan loss provisions at year t. The variable is normalized by
total assets at the beginning of year t ( , −1).

One-period Lagged Tier 1 −1 Ratio of Tier 1 capital to RWA for the year t − 1.

1 Ratio
Change in Non- ∆ Change in non-performing loans estimated as the difference
performing Loans between year t and year t − 1. The variable is normalized by

total assets at the beginning of year t (TAi,t−1).

Change in total loans ∆ Change in total loans at year t estimated as the difference of the
bank’s total loans between year t and t − 1. The variable is

normalized by total assets at the beginning of year t (TAi,t−1).

Leverage Ratio Leverage ratio equal to total debt to total common equity for
bank I at time t.
GDP Growth Rate The country-prevailing GDP growth rate at time t.
Inflation Rate The country prevailing inflation rate at time t.
Bank Type Dummy Dummy variable equal 1 for IBs; 0 for CBs.
Financial Crisis Time dummy equal 1 for the sample period of 2007-2009 and
0 otherwise.
Listing Status Dummy variable for the listing status of bank i at time t, equal
1 if the bank is listed; 0 otherwise.
One-period Lagged , −1
Total assets for bank i at time t-1
Total Assets
Dummy Loss A dummy variable equals 1 if the bank reports negative/zero
earnings and zero otherwise.
Interaction LOSS x An interaction variable reflecting the slop difference for
1 −1 Tier 1t−1 between income and loss generating banks.

Country Governance: ,,
A set of country-level governance indicators (indexed by
country) at time t.
Rule of Law , Captures perceptions of the extent to which agents have
confidence in and abide by the rules of society, and in
particular the quality of contract enforcement, property rights,
the police, and the courts, as well as the likelihood of crime
and violence
Regulatory Quality ,
Captures perceptions of the ability of the government to
formulate and implement sound policies and regulations that
permit and promote private sector development
Notes: definitions and notations for each test variable.

23
 Table 3 Descriptive Statistics for the Sample Period 2007-2013
Variables Units Mean Median Standard Min. Max.
Deviation
Panel A: Full Sample
, % 0.085 0.023 0.056 -0.184 0.864
,− % 23.062 18.435 17.571 4.39 25.830
∆ , % 0.023 0.011 0.042 -0.331 0.243
∆ , % 0.194 0.156 0.932 -0.719 0.574
, % 5.228 5.414 2.878 0.155 12.964
, % 14.300 12.954 11.012 -15.157 44.608
, % 3.539 2.796 3.526 -4.863 15.050
, % 66.208 64.455 5.037 61.137 82.464
,
% 68.285 71.075 6.405 56.863 75.829
,− $m 6,985.016 2,075.931 13,134.510 120.000 121,836.000
Panel B : IBs subsample
, % 0.080 0.027 0.018 -0.023 0.864
,− % 31.300 22.185 24.467 10.100 25.830
∆ , % 0.050 0.016 0.029 -0.045 0.098
∆ , % 0.215 0.165 0.188 -0.719 0.574
, % 3.918 3.031 3.373 0.155 12.964
,
% 13.976 15.441 11.011 -15.157 44.608
, % 3.007 2.755 2.997 -4.863 15.050
, % 66.839 65.877 4.739 61.137 82.464
, % 70.738 72.816 5.175 56.863 75.829
,−
$m 3,558.098 1,361.221 5,352.098 120.000 30,068.000
Panel C: CBs Subsample
, % 0.087 0.021 0.067 -0.184 0.745
,− % 18.305 16.69 7.086 4.39 23.620
∆ , % 0.018 0.012 0.043 -0.331 0.243
∆ , % 0.183 0.147 0.156 -0.565 0.217
, % 6.321 6.281 1.771 2.625 10.618
,
% 14.501 12.304 11.021 -15.157 44.608
, % 3.992 3.257 3.867 -4.863 15.050
, % 65.669 63.158 5.225 61.137 82.464
,
% 66.192 64.706 6.615 56.863 75.829
,− $m 8,621.094 2,672.254 14,427.080 419.000 121,836.000
Notes:
The table reports the descriptive statistics for the variables considered in our analyses. The observation period is
2007 to 2013. The $m denotes US dollars in millions.

Panel A - results for the full sample including CBs and IBs with 441bank-year observations.
Panel B - results for IBs subsample comprising 203 bank-year observations.
Panel C - results for the subset of CBs representing 238 bank-year observations.

24
Table 4 Pearson (Spearman) Correlation Analysis above (below) the Diagonal for the Sample Period 2007- 2013

Variables , 1 , −1 ∆ , ∆ , , , , ,
,

, 1 0.019*** 0.049 0.057 -0.074 -0.081* -0.011 -0.100* 0.086*

(0.000) (0.411) (0.918) (0.375) (0.095) (0.813) (0.045) (0.085)
1 , −1 0.140*** 1 0.051 -0.056 -0.369*** -0.072 -0.098** -0.045 0.216***
(0.001) (0.403) (0.309) (0.000) (0.118) (0.033) (0.346) (0.000)
∆ , 0.256** -0.014 1 0.153** 0.086 -0.058 -0.062 -0.029 0.010
(0.030) (0.907) (0.008) (0.934) (0.321) (0.288) (0.642) (0.872)
∆ , -0.028 -0.372*** -0.037 1 0.042* 0.016 0.035 0.222*** 0.140**
(0.815) (0.001) (0.703) (0.064) (0.754) (0.483) (0.000) (0.008)
, 0.184 -0.376*** 0.140 0.047 1 0.029 0.243*** -0.171** -
0.355***
(0.123) (0.000) (0.144) (0.700) (0.709) (0.001) (0.047) (0.000)
,
-0.228* -0.025 -0.238** 0.103 -0.057 1 0.436*** 0.232*** -
0.178***
(0.054) (0.833) (0.012) (0.388) (0.962) (0.000) (0.000) (0.000)
,
0.447*** -0.131 -0.047 -0.067 0.221* -0.387** 1 -0.107** -
0.403***
(0.000) (0.272) (0.623) (0.577) (0.063) (0.004) (0.007) (0.000)
, - -0.154 0.029 0.120 -0.275** 0.332** -0.280*** 1 0.381***
0.423*** (0.196) (0.642) (0.315) (0.020) (0.004) (0.000) (0.000)
(0.000)
,
- -0.058 0.010 -0.101 -0.026 0.258** -0.322*** 0.430*** 1
0.354*** (0.629) (0.872) (0.401) (0.829) (0.028) (0.000) (0.000)
(0.000)
Notes: Table reports for the full sample the pairwise correlation coefficients for bank specific (LLP, Tier 1, ∆ ,∆ , LEV), macroeconomic (GDP, INF) and regulatory environment (ROL, RQ) variables included in
our estimation. *,**,*** denote significance at the 10%,5% and 1% respectively

25
 Table 5 Regression of LLP on Lagged Tier 1 Ratio for the Sample Period 2007-2013
, ∆ , ∆ ,
= + + + + + + +

,−
,− ,
,− ,−

+ + + + ∑ + +

, , , ,,
=

Variables Predicted Variant (1) Variant (2)

Sign
,− + 0.087*** 0.014***
(0.000) (0.000)
∆ , + 0.013** 0.016**
(0.046) (0.032)
∆ , + 0.054** 0.021*
(0.003) (0.062)
, + 0.021 0.025
(0.514) (0.397)
, + -0.028 -0.022
(0.825) (0.869)
, - -0.094*** -0.045**
(0.000) (0.027)
, - 0.032*** 0.016
(0.000) (0.381)
, - -0.026 -0.015
(0.222) (0.149)

,
- -0.011 -0.017
(0.452) (0.044)
+ 0.019*** 0.016**
(0.001) (0.035)
+ 0.016**
(0.024)
∗,− -0.054
(0.443)

Year Fixed effects YES YES

Bank specific effects YES YES
Hausman Tests 19.18
(0.000)
Adjusted 0.333 0.521
Bank-Year Observations 441 441
Notes: The table reports the Fixed Effects estimations for testing and under the full sample employing
different variants of equation (1). Under we use Variant (1). For testing ; Variant
(2) is used to test for the impact of managing regulatory capital ratios for each bank type on average and
during the financial crisis. *,**, and *** denote significance at the 10%, 5%, and 1% levels,
respectively.

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 Table 6 Regression of LLP on Lagged Tier 1 Ratio for IBs and CBs Subsamples
, ∆ , ∆ ,
= + + + + + + +

,− ,− ,− ,− , ,

+ + + ∑ + +

, , ,,
=

Variables Predicted Sign IBs Subsample CBs Subsample

,− + 0.037 0.024***
(0.215) (0.001)
∆ , + 0.066** 0.020**
(0.013) (0.025)
∆ , + 0.043** -0.035
(0.035) (0.670)
, + -0.056* 0.048**
(0.059) (0.003)

,
+ 0.072** -0.063
(0.026) (0.671)
, - -0.068** -0.025**
(0.042) (0.007)

,
- 0.037** -0.011
(0.044) (0.614)

, - -0.030 -0.020
(0.121) (0.235)

,
- -0.013 -0.010
(0.136) (0.244)
+ 0.057* 0.017***
(0.059) (0.006)
Year Fixed effects YES YES
Bank specific effects YES YES
Adjusted 0.379 0.325
Bank-Year 203 238
Observations
Notes: The table reports the Fixed Effects estimations for testingwithin each of the IBs and CBs
subsamples. Under we predict lower association between LLP and ,− in IBs as compared to

CBs. *,**, and *** denote significance at the 10%, 5%, and 1% levels, respectively.

- 27 -
 Table 7 Controlling for Income Smoothing
∆ ∆
,
= + + + ,
+ ,
+
, ,−

,−
,− ,−

++ , + , + , , + , ,

+ ∑ ++

Variables Predicted Full IBs Sub-sample CBs Sub-sample

Sign Sample
, ×,− + 0.013*** -0.037 0.024***
(0.000) (0.215) (0.000)
, - -0.023** -0.079** -0.025**
(0.003) (0.002) (0.002)
∆ , + 0.017** -0.066 0.020**
(0.030) (0.128) (0.025)
∆ , + 0.089 0.043** -0.035
(0.832) (0.035) (0.665)
, + 0.023** 0.059 -0.048
(0.041) (0.399) (0.153)
, + 0.017 0.072** 0.063*
(0.900) (0.026) (0.071)
, - -0.015 -0.068** -0.025
(0.729) (0.042) (0.637)

,
- 0.097 0.037** -0.011
(0.598) (0.044) (0.614)
, - -0.018 -0.029 -0.020
(0.120) (0.521) (0.435)

,
- -0.011 -0.013 -0.011
(0.188) (0.136) (0.244)
+ 0.061*** 0.057* 0.017**
(0.000) (0.059) (0.030)
+ 0.023**
(0.037)
Adjusted 0.379 0.337 0.346
Bank-Year Observations 441 203 238
Notes: The table reports the Fixed-effects estimations for testing the capital management hypothesis
after controlling for income-smoothing incentive. Results are reported for the full sample and each of the
Sub-samples. *,**, and *** denote significance at the 10%, 5%, and 1% levels, respectively.

- 28 -