Ebook Regulatory Capital And Earnings Management In Banks: The Case Of Loan Sales And Securitizations
In this paper, I investigate whether banks use loan sales and securitizations to influence accounting information for regulatory and other purposes. My analysis includes whether gains from whole loan sales and loan securitizations with retained interests have different properties. The income recognition from securitizations provides useful insights about the trade-offs between historical cost accounting – which applies to loans before a securitization– and fair value accounting –which applies to financial instruments retained after a securitization.
Securitization is the process of transferring illiquid assets such as mortgages, credit card receivables, business loans, and leases to third parties. The ability to transfer otherwise illiquid loans in secondary markets allows banks to focus on core competencies in banking such as origination, servicing, and management of loan portfolios. In addition, banks use securitizations as a source of funding and a tool for risk management.
Securitization also enables banks to influence balance sheet and income statement information. Securitization transactions can be accounted for as sales or secured borrowings. Securitizations that are accounted for as sales increase regulatory capital by allowing the capitalization of expected future income. The gains or losses from securitization (gains hereafter) result from the discretion in the selection of loans to be securitized and the discretion in the valuation of retained interests after securitization. Since loans constitute over half of the balance sheet of an average commercial bank (Table 1), securitization of loans provides significant opportunities to affect regulatory and financial reporting outcomes.
I use regulatory bank filings between 1997 and 2000 and document both regulatory capital and earnings management using gains. These results are generally consistent with prior studies of discretionary behavior in the banking industry. Several studies have investigated whether regulation, taxes, private contracts (e.g. compensation), and communication of private information to capital markets motivate regulatory capital and earnings management in banks. Moyer (1990), Beatty, Chamberlain, and Magliolo (1995), Collins, Shackelford, and Wahlen (1995), Kim and Kross (1998) and Ahmed, Takeda, and Thomas (1999) find evidence that regulatory capital and earnings outcomes influence managers’ discretion in loan loss provisions, charge-offs, and miscellaneous gains. For example, the latter two studies find a reduction in loan loss allowances, after risk-based capital regulations limited their inclusion in capital. Tax considerations have not been found to have a strong influence (Beatty et al. [1995], Collins et al. [1995], Scholes, Wilson, and Wolfson [1990]).
Prior studies on securitization in banking, such as Pavel and Phillis (1987), Jagtiani, Saunders and Udell (1995), have not examined the accounting impact and have found weak evidence of regulatory capital motivations. In contrast, prior studies of accounting discretion in banking, such as Beatty et al. (1995), have not analyzed loan sales as a distinct class and have combined the securitization gains with the gains from securities’ and other assets’ sales. In this paper, I simultaneously analyze the decision to sell or securitize loans and the gains recognized as a result of the sale or securitization. Further, I contrast gains from whole loan sales which are “pure” asset sales with gains from securitizations with the further involvement by the securitizer which involves capitalization of expected future income.
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