Earnings smoothing and systemic risk in the banking industry

This study examines the relation between earnings smoothing through loan loss provision (LLP smoothing) and systemic risk in the 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 LLP smoothing as a reaction to common risk exposure, but there is no evidence that the relation works through the mechanism of bank interconnectedness. The informativeness property of LLP smoothing or bank-specific risk does not affect the relation either. In addition, managerial characteristics influence the link between LLP smoothing and systemic risk, with the association weakening for male managers or managers with strong risk-taking incentives. Moreover, stronger monitoring over LLP smoothing by long-term debtholders, financial analysts, and Big-Four auditors is found to enhance the negative relation between LLP smoothing and systemic risk.