The Role of Loan Loss Provisions in Earnings Management and Capital Management: The Chinese Experience

Banks’ loan loss provisions play an important role in bank stability and soundness. It can help banks prevent credit risk, smooth income, manage regulatory capital and also improve their performance. This paper examines the loan loss provisions behaviours in Chinese banking system and how they are correlated with the earnings management and capital management. Based on 260 banks over the period of 2011-2017, both the Fixed Effects model and the System Generalized Method of Moments estimator are used to assist our analysis. The findings indicate that loan loss provisions are not used as a tool for income smoothing since the results show that banks may decrease their provisions when their earnings increase. However, there is a significant proof for capital management in Chinese banks, which indicates that Chinese banks may use loan loss provisions to manage their capital ratios in order to meet regulatory requirements. The lagged dependent variable is also significant, showing that Chinese banks may adjust provisions according to the amount in previous years. In terms of other control variables, the non-performing loans, the gross loans, the GDP growth rate and the unemployment rate are all significant, indicating that they may have great impacts on loan loss provisions behaviours in China