Do Bank Managers Strategically Exploit the Wiggle Room in Loan Loss Provisioning for Securitized Loan Seller’s Interests?

Extant literature on the use of securitization as an earnings management tool focuses solely on the one-off use of securitization gains/losses to manage earnings at the inception of securitization transactions. In contrast, I conjecture that securitizations provide managers with greater wiggle room to manage earnings via loan loss provisions (LLP) for retained seller’s interest of securitized loans (SIL) over the term of the loan because managers possess relatively less information about securitized loans vis-à-vis regular loans. Consistent with this conjecture, I find that bank managers’ use of LLP for income smoothing is greater when the bank holds the SIL and is increasing in the ratio of SIL to total loans. Further tests reveal that the incremental use of the SIL’s LLP for income smoothing is lower for public banks because they face greater external capital market scrutiny than private banks. I also find that SIL is particularly useful for income smoothing in the fourth quarter, when greater auditor scrutiny makes it more difficult to manage earnings via LLP of non-securitized loans.