Earnings smoothing and systematic risk in the banking industry

This study examines the relation between earnings smoothing through loan loss provision (LLP smoothing) and systemic risk in the US banking sector. We find that LLP smoothing is negatively associated with a bank’s contribution to systemic risk in general and in both boom and bust periods. We further find that this association stems from the counter-cyclical cushioning role of beneficial LLP smoothing as a reaction to common risk exposure but does not work through the mechanism of bank interconnectedness or bank-specific risk. Moreover, the effect of LLP smoothing on systemic risk becomes weaker for banks with more heterogeneous loans and for banks with male managers or managers who have strong risktaking incentives. Finally, we find that the effect is more pronounced for banks under enhanced monitoring by long-term debtholders, financial analysts, and Big-Four auditors in connection with LLP smoothing.