From the financial aspects, the solvency risks show that there are chances of the institutions being declared bankrupt. It is important for the financial institutions to retain adequate capital to solve the conflicts that arise between the institutions, depositors, creditors as well as guarantors (Hsieh & Wu, 2012). In regards to the capital management framework, banks offer confidence to their stakeholders through stability as well as security. Given that capital is considered to absorb losses that are unexpected from the liquidity risks, interest rate risks and credit risks, LLPs have been used in European banks (Hsieh & Wu, 2012).
A sample of 91 banks in 18 European countries in a ten-year period compared the earnings management behavior before adoption of IFRS standards (Manel Hadriche, 2015). The previous research suggested that the main tool of managing the banks earnings is the loan loss provisions. The international accounting standards offered guidelines regarding the establishment of the loan loss provisions as well as the limits of the managers’ ability in exercising flexibility in order to determine provisions. If the use of LLPS in earnings management were limited, then the managers found evidence of lowering the earnings management. Given that capital adequacy ratios and earnings management were intrinsically related, the managers examined the effect of IFRS on capital management (Rivard, Bland, & Hatfield Morris, 2003). After adjusting the macro-economic conditions as well as bank, sizes it was found that adopting the IFRS changed the earnings management behavior significantly. Risky banks in the sample under study engaged in greater earnings management in comparison to the less vulnerable banks (An, Li, & Yu, 2016). However, the vulnerable banks reduced the opportunistic behavior during the post IFRS period. Before the Basel I banks that attempted to minimize the loan loss reserves in order to increase earnings affected the capital adequacy ratios because the loan loss reserves included in the capital adequacy ratio numerator. However, the Basel I framework reduced the loan loss reserves incorporated in the capital adequacy ratio to 1.25% in regards to the risk weighted assets.
Given that the risk-weighted assets were not significant element of the numerator, banks had an incentive of reducing the loan loss reserves without affecting the capital adequacy ratio negatively. It was concluded that this action encouraged the bank managers to use LLPs in earnings management. In January,2008, Basel II was established to generate international accounting standards that had an objective of guarding the banks against the financial and operational risks. However, the Basel II accord did not adjust the structure of capital adequacy ratio in relation to amount of loan loss reserves included in the numerator. There was a requirement for banks in regards to separation of loans in categories in reference to the probability of defaulting. This was intended to minimize the discretionary decisions by the managers (Khurana & Kim, 2003).
The findings from the study on European Banks showed that banks were able to manipulate their earnings via LLPs, however, the adoption of IFRS mitigated the management of earnings behavior. In addition, it was found that banks that were vulnerable to market risks engaged in earnings management via LLPs before the implementation of the IFRS guidelines (Manel Hadriche, 2015).
In regards to smoothing of income, derivative instruments are natural tools that financial institutions especially banks use to hedge their exposure towards the liabilities of interest rate, interest rate risks as well as the exchange rate risks. Effective hedging strategy allows banks to have smoother income stream over time. Evidence show that the managers exhibit inclination towards smooth reporting of the incomes and use the reported discretion via the loan loss provisions. According to the SFAS 133, derivatives, which do not qualify to be hedges, are classified as market to trading assets that have the ability of increasing the income volatility. There is evidence that banks, which report non-zero transactions, depend on loan loss provisions in order to smooth income. Smoothing of income through the LLPs affects the discretionary account in banks. They show the importance of earnings management by depending on discretionary accruals with an intention of reporting smooth income streams in the institutions. A study on 2283 banks around the world have showed that 83% of the banks reported unrealized gains by adopting smooth income strategies through the LLPs. Approximately, 10% of the banks were regarded as ineffective hedgers because of the variations in the income statements from 1999 to 2008. In addition, the SFAS 133 affected the effectiveness of the financial institutions to smooth income via hedging and as a result increasing the income volatility. On the other hand, banks that were not affected by the SFAS 133 showed small changes in regards to smoothing income via LLPs from 1990-2005.
In reference to the quarterly data in a study evaluating the banks behavior in 30 banks from Australia from 2003 to 2015, there was evidence of negative relationship between the capital buffers targeted and the nature of business cycles. The results supported the notion that buffer on capital conservation as well as the buffer on countercyclical capital under the Basel III addresses the incentive of the banks to engage in capital management through pro-cyclical behavior. In addition, there was proof of forward looking behaviors in banks that have chances of minimizing the effect of changes in the credit market on their operations related to lending. Studies show that banks have an incentive of setting high capital targets if the demand of loanable funds increases (Khurana & Kim, 2003). High capital buffers sustained by internal ratings based financial institutions mitigate against the risk model identified by capital requirements applying the internal models. In reference to costs of operations, studies have showed that financial institutions, especially banks economize on their capital levels if the competitive limits exceed the level at which the institutions pass the costs of surplus capital on their clients (Frankel, Johnson, & Nelson, 2002).
Numerous reasons have been identified in order to explain why banks sustain more capital in reference to the requirements by the regulators. Banks evaluate their market risks different from the evaluation by the prudential regulators applying specific stress testing programs and economic capital models. Banks have an incentive of accumulating excess capital in order to predict the soundness of the market as well as satisfy the requirements of the rating agencies. After the economic crisis in 2008 to 2009, more emphasis on regulatory reforms were to reduce the pro-cyclical impacts on the banks requirements in regards to capital. In the periods of cyclical downturns , losses affect the bank’s capital negatively, and the risk based requirements under the Basel II guidelines are more onerous. Research studies have showed that the credit crunch risk transpiring during the periods of economic crisis increase if banks act to higher perceived risks though establishment of capital buffers (Rivard, Bland, & Hatfield Morris, 2003). This is in line with the prediction that exact capital buffers in these institutions show a negative relationship with the business cycles.
In 2013, Basel III capital framework was adopted in UK to address the problems in the 2008-2009 financial crisis. This framework established the least requirement of common equity by raising the quantity as well as the quality of regulatory capital base (Manel Hadriche, 2015). This framework established the requirements of common tier 1 capital base through which the minimum requirement of tier 1 capital are increased to 6% of the risk weighted assets as well as 4.5% of the risk weighted assets (Mamatzakis, 2012). In relation to the study of Australian Banks, it was found that banks exposed to more lending have more buffers imposed on minimum levels of capital. In addition, it was found that banks had an incentive of higher capital buffers if the business confidence was high and during the periods when competitive forces in the financial industry was less (Rivard, Bland, & Hatfield Morris, 2003). Large banks as well as financial institutions with high returns and high trading books were found to have small capital buffers (Rivard, Bland, & Hatfield Morris, 2003). The following table shows the results after buffering the regulatory capital in the Australian banking industry.
Capital ratio (tier 1)
Total capital ratio
Loans to business institutions
Loanable funds to individuals and households
Loanable funds to government
Return on Equity % per year
Business confidence % per year
(Hsieh & Wu, 2012)
The results above are in line with the backward looking measures in regards to the exact regulatory capital buffers in respect to their effects on various variables identified.
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