2. Hypotheses Development

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2. Hypotheses Development

  1. 1. Loan loss provision and bank capital management changes under Basel Accord Zhou Yunxia∗ Ph.D Candidate Finance and Accounting Department NUS Business School March, 2007 Abstract This paper empirically examines how new capital adequacy regulation under Basel Accord change management manipulation mechanisms of the U.S. banking industry after 1991. I find strong evidence that bank firms are more likely to decrease loan loss provision to manipulate regulatory capital upward when Tier I capital is low, instead of increasing as they did before Basel Accord. On the contrary, they push loan loss provision upward when Tier II capital falls short of threshold, and when loan loss reserve to risk-weighted total assets ratio is at low level. This is the first paper investigate features of both major capital components and their associated capital management incentives separately. The cross-sectional variations of identified new manipulation mechanisms are directly examined as well, as a function of three factors—size, non- audit service purchase level and its variability. Consistent with literature evidences in other industries, high level of non-audit service fees encourage bank firms to involve in capital management more. However, non-audit service purchase of consistent frequency and magnitude (low variability) suppresses manipulation actions. Furthermore, capital management is more prevail in firms of small size (low total assets). All of these evidences provide directional references to improve regulators’ supervision and monitoring efficiency under the Basel Capital Accord. Key words: Basel Accord; Capital Management; Loan Loss Provision; Non-Audit Service JEL classification: C80 G10 M41 M42  Email: g0201925@nus.edu.sg. I gratefully acknowledge and thank the comments from my supervisor Professor Michael Shih Sheng-Hua and his dedicated guidance. I also highly appreciate helpful suggestions and comments from my dissertation committee: Edmund Keung and Anand Srinivasan. All errors are mine.
  2. 2. 1. Introduction This paper examines the impact of Basel Capital Accord on managerial manipulation of United States banks. Previous research so far has only focused on the marginal transition effect of different capital regulation environments before and after Basel implementation. This paper’s interest is to provide much more direct and complete evidences of how bank firm managers react in response to specific capital policy changes in the Basel Accord regime, and to identify capital manipulation mechanisms changes associated with each major capital components(Tier I and Tier II capital specifically), and their cross-sectional variations. Basel Accord is mainly about regulatory capital framework. Capital adequacy ratio is the key component of this framework and it is defined as percentage of a bank's capital to its highly standardized risk-weighted assets. Cost of falling short of minimum threshold of capital adequacy ratio is very substantial. Specifically, banks could be subject to sanctions, termination of federal insurance or stringent restriction on additional loan deposit and investment. This gives bank management strong capital management incentives to inflate capital adequacy ratios (see Moyer, 1990; Beatty et al, 1995; Kim and Kross, 1998; Ahmed et al, 1999).Without doubt, it is of paramount importance to detect their manipulation actions to facilitate more efficient supervision and monitory of banks and maintain health financial system. However, Moyer (1990) and Beatty et al (1995) can not provide much information since they only investigate banks’ behavior before the Basel change in 1988. Although Kim and Kross (1998) and Ahmed et al (1999) studies are related to capital adequacy policy changes in the new regime, they focus only on the marginal transition effect of capital regulation regime shift. Given the importance of capital manipulation detection and inadequacy of literature evidence on that, this paper tried to provide complete evidence of new capital manipulation mechanisms associated with each Basel capital regulation changes, and their cross-sectional variations. In addition, this paper takes non-audit service into consideration, which is a potentially important economic determinant of manipulation incentives not incorporated in prior capital research works. -1-
  3. 3. This paper investigates the bank firms’ capital management via loan loss provision 1.Loan loss provision is a relatively large accrual in banking sector and used as a popular performance manipulation vehicle. According to Statement of Financial Accounting Standards (SFAS) No.5, managers can execute judgment in selecting amount and decide timing of loan loss provision. Furthermore, bank managers have private information of loan portfolios, which are very costly to be obtained by outside auditors and regulators. Therefore, their discretion on loan loss provisions can not be easily verified or detected. Moyer (1990) and Beatty et al. (1995) report that bank firms use loan loss provisions to reduce expected regulatory costs associated with violating capital requirements. Prior to 1988, loan loss provision has positive impact on bank firm’s regulatory capitals. Total regulatory capital before Basel Accord is mainly divided into two parts: primary capital and supplementary capital. Primary capital consists of two key elements: equity capital and disclosed reserves (including common stocks, retained earnings, loan loss reserve, perpetual preference shares and mandatory convertible debt). They are wholly visible in the published accounts and common to judgments of capital adequacy of all countries’ banking systems. As critical indicator of profit margins and capacity to compete, they reflect both the quality and level of capital resources maintained by a bank. Supplementary capital is largely consisting of reserves, general provisions, hybrid instrument and subordinate term debt. Banks by mandatory must maintain both primary and total capital ratios above certain minimum requirement levels, in particular, primary capital ratio must exceed 5.5% and total capital ratio over 6%. The net effect of loan loss provision on primary capital is the tax shield of loan loss provision since it decreases retained earnings and increase loan loss reserve, which are two important compositions of primary capital (see Appendix A for detailed explanation of ratio computation). Therefore, banks with low capital 1 The capital –raising target could also be reached via the security gains and losses, loan charge-offs, capital notes, common stock, preferred stock, and dividends. -2-
  4. 4. ratios would like to manipulate capital ratios upward via inflation of loan loss provisions (see Moyer, 1990; Beatty et al, 1995; Kim and Kross, 1998; Ahmed et al, 1999). U.S banks adopted Basel Capital Accord in 1991. This new capital requirement system changes the composition and computation of capital adequacy ratios to incorporate underlying risks that banks face. In particular, loan loss reserve is removed from primary capital and it is renamed as Tier I capital (mainly equity capital and published reserves from post-tax retained earnings). Tier II capital is basically the secondary capital under the old regime, however, loan loss reserve is added with an upper limit of 1.25% of risk-weighted assets. Furthermore, it brings up the total capital ratio minimum level from of 6% to 8 %( 8% at the end of 1992; from 1988 to December, 1990, minimum total capital ratio is 7.25%) to be “well –capitalized”. These changes substantially alter the association between regulatory capitals and loan loss provision, leading us to make new predictions on bank management behaviors. Using a sample of 1609 bank holding firm-year observations that file Y-9C reports with the Federal Reserve from year 2000 to 2005, new capital management evidences in response to regulation changes under Basel Accord are identified and explained. First, bank managers would like to reduce loan loss provision (instead of increase as they did prior to 1988) to preserve Tier I capital ratio. As loan loss reserve is no longer included in Tier I capital, the overall effect of loan loss provision would be reduction of retained earnings only, that is, there is a positive association between loan loss provision and Tier I capital since Basel Accord ( see Appendix B for further explanation). This is totally different from Moyer (1990) and Beatty et al. (1995) which document a negative relationship under old capital requirement regime. However, the results are supported by Kim and Kross (1998) and Ahemad et al (1999). Although they did not provide direct evidences, they find out that banks have lower loan loss provision ever since 1991 relative to the old regime. Second, opposite to Tier I capital, loan loss provision is negatively related to Tier II capital. That is, bank firms would engage in capital management via increasing loan loss provision, and this incentive is particularly strong when loan loss reserve to risk-weighted assets -3-
  5. 5. ratio is at low level. Under Basel Accord, loan loss reserve is shift from Tier I capital to Tier II capital. Different from Tier I capital, one unit increase of loan loss provision increases Tier II capital by the same magnitude. Basel Accord gives bank mangers a new option to reach total capital requirement level besides Tier I capital since total capital is the sum of Tier I and Tier II capital. Furthermore, loan loss reserve qualified to be included in Tier II capital is up to 1.25% of risk-weighted assets. The upper bound definition gives banks with low loan loss reserve stronger incentive to increase loan loss provision to enjoy the maximum benefit. Bank firms with high level of loan loss reserve usually have large capital, facing weaker capital management incentives. Loan loss provisions are also used for earnings management purpose (Greenawalt and Sinkey, 1988; Beatty et al., 1995; Collins et al, 1995).This earnings management incentive is reexamined to see if it holds in a more recent time period after controlling significant capital regulatory changes. Results show a positive relation between loan loss provision and earnings before loan loss provision and tax (EBTP).This is consistent with prior papers since loan loss provision works as a pure expense in the profit and loss statement to decrease taxable income. In the old regime, loan loss provision has opposite effect on earnings and capitals (Although loan loss provision increase primary capital, doing so would decrease taxable income). Different from that, Basel Accord makes earnings and capital management incentive consistent, reducing loan loss provision not only help to maintain Tier I regulatory capital, but also increase taxable income and smooth reported earnings. Besides investigation of new capital management mechanisms induced by Basel capital adequacy rules changes, the cross-sectional variations of the mechanisms as a function of three factors are also examined, namely, size effect, non-audit service purchase magnitude and its variability. With respect to size, firms of small total assets are more likely to engage in capital manipulations via loan loss provision. Higher litigation risk and reputation cost of large firms constrain big firms’ discretionary actions. Compare to their large counterpart, small banks’ -4-
  6. 6. performance are more volatile while facing the same level of earnings and capital benchmark, and the strong earnings smooth demand give them high manipulation incentives. Their less sophisticated internal control systems and incompetent internal auditors also encourage them to do so. With respect to non-audit service, consistent with literature evidences in other industries, high level of non-audit service purchases encourages bank firms to exercise more discretion on earnings and capitals. Surprisingly, contradictory to the prevailing “economic bond” theory (providing rents to auditors by non-audit service purchase strengthens the economic bond between auditee and auditors, which encourage firms to engage in manipulations), I find that low variability of non-audit service purchase suppress manipulation actions, that is, firms purchased non-audit services with consistent recurrence frequency and magnitude are less likely to manipulate performance. This could be the result of Sarbanes-Oxley Act and SEC (2000)2 implementation. Auditor independence becomes a big concern of researchers and regulators, and quite lots of intervention come out after 2000.Continuous non-audit service purchase does not only pose more litigation risk to auditors, keep providing rent to auditors give investors perception of impaired independence and low reporting quality to trigger negative market reaction to bank firms as a consequence. The prevail of non-audit service in the same period of Basel Accord implementation motivate this paper to empirically investigate its impact on bank firms’ manipulation behavior via loan loss provision after controlling the capital adequacy rules changes. Regulators including the Federal Reserve are very interested in external audits of institutions it supervises and take auditor’s opinion as a crucial reference to facilitate their supervision and monitoring. Banks with total assets of $500 million or more are required by statute to have an external auditor. The benefit 2 After implementation of Sarbanes-Oxley Act, SEC filed “Final Rule: Revision of the Commission's Auditor Independence Requirements” (the “rule”) [File No. S7-13-00] in November 2000, requires firms, starting from February 5, 2001, to disclose non-audit service fees beside audit fees. Detailed definition and contents of non-audit service are described in Audit and Non-Audit Services Pre-Approval Policy. -5-
  7. 7. derived from an external audit, however, is contingent upon the auditor's competence and objectivity. It is widely evidenced that non-audit service is associated with observable difference in earnings quality and reporting proxies, and has adverse effect on earnings quality in many industries (see DeAngelo 1981; Beck et al. 1988; Magee and Tseng 1990; Francis and Ke, 2001; Frankel et al 2002; DeFond et al. 2002; Ashbaugh et al, 2003). However, the literature leaves banking industry untouched. Loan loss provision as a widely used measure for financial reporting quality in banking industry enables this paper to empirically investigate the association between non-audit fee and discretion of bank management. However, this paper does not attempt to investigate whether auditor independence is factually impaired. This stand-alone marginal analysis can not tell us much about that without comprehensive investigation of detailed institutional settings and specific audit contracting incentives. Evidence of factual impairments is very limited in literature due to the fact that auditor independence is not readily observable with real data, therefore advanced and rigorous models which can probe subjective issues are needed. Thus I regard this part only as a direct test of association between non-audit service and loan loss provision. However, the results do provide directional reference to regulators and researchers for further examinations in auditor independence issues. This paper contributes to the literature of both capital adequacy regulatory system and loan loss provision in several ways. First, it identified and explained positive association between loan loss provision and Tier I capital under Basel Accord. This is a new finding in capital management literature. Moreover, different from conflicting incentives related to loan loss provision on capitals and earnings, new capital rules enable bank firms to maintain regulatory capital and smooth reported earnings at the same time via reducing loan loss provision. Second, Tier II capital and loan loss reserve ratio are directly examined and the associated management mechanisms are excavated. These two factors are very important as they are related to major capital rules changes in Basel Accord and influence bank management choice substantially. However, they are not examined before. All the above findings enrich our knowledge of the -6-
  8. 8. effectiveness of Basel Accord and correspondent management behaviors in the new capital regime. Third, the statistical association between non-audit service and loan loss provision is analyzed. This is the first time non-audit service issue is investigated in banking industry. Moreover, different from studies in other industries, the impact of non-audit service purchase variety is examined as well beside the popular magnitude measure. This provides a new angle for further experiments on auditor independence issue, especially the effectiveness of SEC rules on non-audit service disclosure requirements. In a word, findings in this paper shed some lights on the mechanism and extent of bank management behavior under new Basel capital rules and their cross-sectional variations, trying to provide valuable reference to regulators for higher monitoring and supervision oversight efficiency. Basel Committee on Banking Supervision keeps revising capital rules over years. Besides an amendment incorporated market risks in 1996, they issued an agreed text and a comprehensive version of Basel II Framework in June 2004 and July 2006 respectively. Basel II intends to apply more forward-looking approach to encourage banks to identify the market, credit and operation risks they may face in the future to facilitate better capital supervision. However, the fundamental elements of the 1988 Accord are intact. Therefore, results of this paper are still applicable to banks today. The next section presents detailed hypothesis tested in this paper, followed by experimental model design in section 3. Sample and data description are presented in section 4, and results are discussed in section 5. Section 6 contains closing remarks. 2. Hypotheses Development This section begins with a discussion on the association between loan loss provision and banks’ manipulative behaviors. And next, I develop hypotheses on specific capital and earnings management in the new Basel capital adequacy regime. Finally, I discuss cross-sectional -7-
  9. 9. variations of management incentives as a function of three factors, size effect, non-audit service purchase magnitude and its variability. 2.1 Bank manipulation and loan loss provision Bank loan loss provision is very sensitive to capital and earnings manipulation incentives. First of all, it is closely related to regulatory capital measures. Loan loss provision is a very important proxy for default risk, reflecting increase of expected future loan losses level in the current period. Loan portfolios are typically 10-15 times larger than equity in banking industry, thus default risk has critical impact on banks’ market valuations, and so does loan loss provision. More importantly, as a relatively large accrual for commercial banks, loan loss provision has substantial influence on capital adequacy ratio via loan loss reserve. Capital adequacy ratio is a very important proxy for bank healthiness and it is defined as percentage of a bank's regulatory capital to its highly standardized assets. No matter it is before or after the Basel Accord, loan loss reserve is included in regulatory capitals. In the old regime, it is a paramount component of primary capital; under the Basel framework, although there is an upper limit, loan loss provision is still qualified to be included in Tier II capital. Loan loss provision is closely associated to regulatory capital through its mechanical link to loan loss reserve, one unit increase of loan loss provision technically increase loan loss reserve by the same magnitude. Banks must maintain capital ratios above certain minimum required level, for example, primary capital ratio exceed 5.5% and total capital ratio above 6% in the old capital regime before Basel Accord. Cost of falling below capital adequacy requirement could be substantial. Moyer (1990) point out that “because regulators are empowered to restrict bank operations, a bank with capitals that regulators consider to be inadequate incurs greater regulatory costs than a bank with adequate capital.” Specifically speaking, banks could be subject to sanctions, termination of federal insurance or stringent restriction on additional loan deposit and investment, and banks’ growth perspective could be constrained as a consequence. This tremendous cost of capital -8-
  10. 10. inadequacy gives bank managers high incentive to manipulate capital ratios upward when it falls short of target level. Because of the inherent association between capital ratio and loan loss provision mentioned above, loan loss provision is used a popular capital management tool (see Moyer, 1990; Beatty et al, 1995; Kim and Kross, 1998; Ahmed, Takeda and Thomas, 1999). Moyer (1990) and Beatty et al. (1995) both document a negative relationship between capital ratio and loan loss provisions, indicating that banks with low capital ratios would like to manipulate capital ratios upward via inflating loan loss provision. Both of these two studies investigate banks’ behavior in the old capital regulation regime when loan loss reserve was still included in primary capital. One unit increase of loan loss provision decreases retained earnings by (1-t) unit, t is the tax rate, it increase loan loss reserve by one unit at the same time. The net effect of loan loss provision on primary capital is to increase it by one unit time t. Basel capital adequacy framework shift loan loss reserve from primary capital to Tier II capital, and the management incentives should be changed accordingly. Besides regulatory capital, loan loss provision is sensitive to bank earnings. Taxable net income of bank firms can generally be increased by interest income, service revenues, securities gains and losses, and reduced by interest expense, operating costs, loan loss provision, and income tax expense. It is difficult for bank managers to significantly change interest income or expense, service revenues or operating costs during financial periods, neither adjusts them at year-end. Loan loss provision is the only income component that can be revisable interim and adjustable at year-end. According to Statement of Financial Accounting Standards (SFAS) No.5, managers can execute judgment in selecting amount and decide timing of loan loss provision. This special feature makes it a natural choice of bank managers’ earnings discretion. $1 reduction in loan loss provision can successfully increase net income after tax by $1* (1-t), t is the tax rate. This mechanism is reflected in positive relation between loan loss provisions and earnings (before loan loss provisions) in many prior empirical studies (see Greenawalt and Sinkey, 1988; Beatty et al., 1995; Collins et al, 1995). -9-
  11. 11. Loan loss provision is not only sensitive to capital and earnings measures, it is also highly manageable. First, bank managers’ judgments and discretion are necessary in estimating the loan loss provision each period, and can not possibly be removed or replaced. Second, they have their own private information regarding default risk inherent in loan portfolio which are not accessible or can not be obtained without high cost by outsiders, thus investors and regulators can hardly verify the validity of the managers’ loan loss provision decision. In other words, loan loss provision can be used as a manipulation vehicle by bank management to reach their desired results and without much detection risk within short period. 2.2 Capital management Capital adequacy framework begins a new regime in 1988. Before that, each nation has its own regulatory policies and capital rules to regulate banks and depository institutions. Basel Committee on Banking Supervision introduced a new capital measurement system for the purpose of international convergence of capital measures and capital standards in 1988, which is commonly referred as Basel Capital Accord. United States started to implement Basel Accord in 1991 through issuance of Federal Deposit Insurance Corporation Improvement Act of 1991 3 and it is supervised by Board of Governors of the Federal Reserve System (FRB), Office of the Comptroller of the Currency (OCC) and Federal Deposit Insurance Corporation (FDIC). This new capital system seeks to improve existing rules by aligning regulatory capital requirements more closely to the underlying risks that banks face, and incorporates assets risk weights and off- balance activities into consideration4.More importantly, it changes the composition and 3 Federal Deposit Insurance Corporation Improvement Act of 1991 started the implementation of new capital adequacy framework in 1991,and 1990 is a transitional year, banks in U.S can choose to conform to the old system or to the new one. 4 1988 Basel Accord is mainly designed to assessing capital in relation to credit risk. Supervision institutions are trying to deal with other risks, for example, interest rate risk, operation risk and investment risk in further development of Basel Accord. Furthermore, the relative strength of capital also depends on the quality of a bank’s assets and off-balance sheet exposure. Therefore, risk-weighted assets are designed to be in the denominator of capital ratios. In order to be simple and easy to implement, the framework of weights are designed in a broad-brush basis, only five weights are used, 0, 10, 20, 50 and 100%. - 10 -
  12. 12. computation of capital ratios. In particular, total capital is divides into Tier I capital and Tier II capital. Tier I capital represents shareholders' funds in a bank, that is, their share of the bank's assets after all debts have been repaid to creditors. Basically it is defined as sum of shareholder’s equity, non-cumulative perpetual preference stock and minority interests. Different from primary capital composition prior to 1991, loan loss reserve is removed from Tier I capital. Instead, it counts an important component of Tier II capital. Under the new regime, Tier II capital is defined as a sum of loan loss reserve (up to 1.25% of risk-weighted assets), preference shares, hybrid capital instrument, subordinate term debt and perpetual debt. The minimum capital requirement level is changed as well. In the 1991 new capital regulation framework, banks must at least maintain 4% of Tier I capital ratio and 8% of total capital ratio to be “well –capitalized”, instead of the primary capital ratio exceed 5.5% and total capital ratio over 6% requirement in the old regime. These capital ratios are reviewed regularly on the Call Report or Thrift Financial Report. Moreover, bank firms are required to do “Capital Adequacy Quantitative Disclosures” on a consolidated basis, that is, to disclose total and Tier I capital ratios not only for the top bank group, but for significant bank subsidiaries as well(stand alone or sub-consolidated depending on how the framework is applied). It is worth investigating how bank managers adjust their manipulation mechanisms in response to the above policy changes under Basel Accord. First, the relationship between loan loss provision and Tier I capital is different that of primary capital. Loan loss provision decreases Tier I capital (instead of increasing primary capital in the old regime) since 1991. As loan loss reserve is no longer included in Tier I capital, the overall effect of $1 loan loss provision increase would be reduction of retained earnings by $1 (1-t). This leads us to predict a positive relationship between loan loss provisions and Tier I capital, that is, bank managers would like to preserve Tier I capital by reducing loan loss provision when regulatory capital level is low. This is totally different from Moyer (1990) and Beatty et al (1995) which document a negative relationship under the old capital requirement regime. However, it is partially supported by indirect evidences - 11 -
  13. 13. from Kim and Kross(1998) and Ahemad et al (1999). They find that although loan loss provision still have positive effect on capitals, banks with low capital ratios have lower loan loss provisions after Basel capital requirement implemented. Second, Basel rules give bank managers a new option for total capital management, Tier II capital. Beside 4% of Tier I capital ratio, banks are required to meet the minimum 8% level of total capital threshold. Total capital is sum of Tier I and Tier II capital. Under Basel capital regulation system, although removed from Tier I capital, loan loss reserve still counts as an important part of Tier II capital5. Due to the mechanical link between loan loss provision and loan loss reserve, one unit increase of loan loss provision increases Tier II capital at the same magnitude. Firms with low Tier II capitals can still reach total capital requirement via inflating loan loss provisions, therefore a negative relation between loan loss provision and Tier II capital is expected. Benefit of this manipulation would be maximized if a bank’s loan loss reserve level is low. It is required in the Basel Accord that the amount of: loan loss reserve qualified to be included in Tier II capital is limited up to 1.25% of risk-weighted assets. Firms with loan loss reserve below this upper bound are more likely to engage in Tier II capital management. On the contrary, firms with high loan loss reserve generally have high capital; therefore their capital management incentives are reduced. The above hypotheses are summarized and stated in alternative forms as follows: H1.a: Tier I capital and loan loss provision (as a fraction of average total loan) are positively associated in Basel capital regime. H1.b: Tier II capital and loan loss provision (as a fraction of average total loan) are negatively associated in Basel capital regime. H1.c: Loan loss reserve to risk-adjusted assets ratio and loan loss provision (as a fraction of average total loan) are negatively associated in Basel Capital regime. 5 Basel Capital Accord 1998 April version:”General provisions or general loan-loss reserves are created against the possibility of losses not yet identified. Where they do not reflect a known deterioration in the valuation of particular assets, these reserves qualify for inclusion in tier 2 capital. Where, however, provisions or reserves have been created against identified losses or in respect of an identified deterioration in the value of any asset or group of subsets of assets, …….should therefore not be included in the capital base” - 12 -
  14. 14. 2.3 Earnings management Loan loss provision is sensitive to bank earnings measure and highly manageable. As mentioned, loan loss provision is the only income component that can be revisable interim and adjustable at year-end. According to Statement of Financial Accounting Standards (SFAS) No.5, managers can execute judgment in selecting amount and decide timing of loan loss provision. Furthermore, outsider auditors and regulators have difficulty to obtain and examine the private information of loan portfolios bank managers have, thus bank managers’ loan loss provision decision can not be easily verified or justified. This special feature makes it a natural choice of bank managers’ earnings discretion. Different from capital management context, loan loss provision purely works as an expense to decrease taxable income in profit and loss statement. $1 reduction in loan loss provision can successfully increase net income after tax by $1* (1-t), t is the tax rate. Bank firms therefore would smooth reporting earnings via exercising discretion on the magnitude and timing of loan loss provision. Both Greenawalt and Sinkey (1988) and Collins et al. (1995) find positive relation between loan loss provision and reported earnings, implying that firms with poor real earnings performance generally record less loan loss provision to inflate reported earnings. I expect to observe a significant positive relation between real earning and loan loss provision. Firms with lower the real earnings are more likely to decrease loan loss provision. Besides the mechanical negative impact of loan loss provision on earnings, new Basel capital rules strengthen the above manipulation incentive. Under the Basel capital framework, earnings management incentive becomes consistent with capital incentive, that is, firms can manipulation earnings upward without worrying capital decrease as they did in the old regime. Earning before loan loss provision and tax (EBTP) is used as real earning proxy. In addition, in order to test whether bank firms have different management incentives under low earnings or complete loss circumstances, an alternative variable, LOSS, is used. It represents negative earnings before loan - 13 -
  15. 15. loss provision and tax. Firms with pure loss have strong incentive to manipulate their earnings across above the zero benchmark. Hypothesis related to earnings manipulation could be described as: H2: Earnings before loan loss provision and tax (or loss) and loan loss provision are positively associated in Basel capital regime. 2.4 Non-audit service purchase level and its variability Non-audit service purchase prevails in the same period of Basel Accord implementation, and this motivate this paper to empirically investigate its impact on bank firms’ manipulation behavior via loan loss provision after controlling the capital adequacy rules changes. According to SEC reports, non-audit service purchase substantially increased since the 1990s. During 1990s, proportion of corporations purchased non-audit service increased significantly, from 25% in 1991 to 96% in 2000. Non-audit service fee typically makes up to 51% more than auditor service fee (see Abbott et al. 2003). Auditor independence received the highest attention it ever had from the public investors and researchers since then. Quite many papers have been done to investigate the impact of non-audit service provision on financial reporting quality and auditor independence. The results, however, are quite mixed (Exhibit 2). Some research find negative association between non-audit service provision and discretionary performance measures, that is, the more non-audit service a firm purchased, the lower financial reporting quality it has. This is mainly explained by two schools of theories. First, agency theory characterizes auditor bias as deliberate. It is believed that provision of non-audit service from auditors to auditees generates substantial revenue besides regular audit service and aligns the two parties closely. This economic bond increases auditor’s incentive to acquiesce to client pressure, including deliberately allowing earnings management, which seriously impairs auditor objectivity, and affect the quality and credibility of the financial information as a consequence (Simunic 1984; Beck et al. 1988a). - 14 -
  16. 16. Second, in contrast to agency theory, behavioral literature suggests that psychological heuristics may unconsciously lead auditors to biased judgments (see Beeler and Hunton, 2001). Some studies find no association between non-audit service fee and discretionary accrual. They believe that auditors are unlikely to jeopardize their reputation to attain clients since it takes many years and tremendous effort to build reputation in the market (see Arrun˜ada 1999). In view of increasing public concern of auditor independence and inconsistent literature research results, SEC issued Final Rule of Revision of the Commission's Auditor Independence Requirements (the “rule”) [File No. S7-13-00] (Exhibit 1) in November 2000. This rule requires firms, starting from February 5, 2001, to disclose all detailed audit fees information in recent years. To date, the effectiveness of the rules is not examined empirically. No matter what auditors’ incentives are, no factual evidence of auditor independence impairment or effectiveness of SEC non-audit fee disclosure regulations can be accurately obtained when they are studied in isolation with specific industrial context and comprehensive audit contracting. Banking industry in the new Basel regime provides us a good experimental environment on this research topic. First of all, capital and earnings management incentives and relevant manipulation mechanisms can be clearly identified and tested. Second, loan loss provision is banking industry context better satisfies two critical criteria which make it a good accrual measure in manipulation detection models. Although it is still a controversial question whether the generally accepted accounting principle (GAAP) is violated for firms heavily purchase non-audit service, literature papers do provide evidences that non-audit service is associated with observable difference in earnings quality proxies (see DeAngelo 1981; Beck et al. 1988; Magee and Tseng 1990; Francis and Ke, 2001; Frankel et al 2002; DeFond et al. 2002; Ashbaugh et al, 2003). Loan loss provision is one widely used measure for capital and earnings quality in banking context and very sensitive to hypothesized discretionary behaviors, which is discussed in the beginning of this section. An empirically association between non-audit service fee and loan loss provision is expected. Second, nondiscretionary components of loan loss - 15 -
  17. 17. provision is readily developed, as researchers can rely on generally accepted accounting principles (GAAP) to understand what fundamentals should be reflected in the account in absence of management manipulation, which enables researchers to make a reasonably accurate prediction about the frequency of earnings realization not caused by its nondiscretionary components (Scholes et al 1990).The through understanding of specific manipulation mechanisms and better experimental design enable us to find evidences on these important issues with less bias. More importantly, non-audit service has never been studied in banking industry context before, thus the research in this paper can enrich our industry-specific knowledge on this topic. Same as other industries, follow agency theory, we hypothesize that non-audit service purchase can increase firms’ management incentives, that is ,bank firms purchased high level of non-audit service are more likely to engage in capital or earnings management compare to the firms with less non-audit service purchase. Besides absolute non-audit service purchase magnitude, variability of non-audit service purchase is also expected to affect bank management behaviors. Variability refers to variance of both purchase frequency and magnitude here. In recent years not only more companies purchase non-audit service from incumbent auditors, frequency and magnitude of non-audit service demand also vary vastly across different companies; even for the same firm, frequency and magnitude of purchase could be largely volatile from year to year. As variability could be an important proxy for the tightness of economic bond between auditors and bank firms, manipulation incentives should be hugely different between firms who consume non-audit service regularly and consistently and those who only purchase sparsely. However, I do not have clear prior prediction of the direction of the association between non-audit service purchase variability and banks management behavior. There are two possibilities. First, consistent non-audit service provision may encourage bank firms for more manipulation engagement. Beck et al (1988) find that economic bond between auditor and clients are much stronger when non-audit service revenue is recurring, and can be explained by auditors’ high start-up and switching cost. In the - 16 -
  18. 18. study of relation between agency incentive and non-audit service purchase, Parkash and Venable (1993) find that auditee’s purchase of recurring non-audit service is highly influenced by agency incentives and recurred services are perceived as steady annuity of auditors. On the other hand, regular purchase may constrain management actions. Since year 2001, auditor independence has been a big public consideration and the expected monitoring value of audit is assumed lowered by the market. Furthermore, market reacts very negatively to firms with high non-audit fee whenever they “perceive “it a representation of low audit quality (JERE .R, 2006). As a result, many legislative interventions come out aimed at restricting non-audit service supply. Continuous and consistent non-audit service provision would not only pose high litigation risk to auditors because of potential independence impairment, regularly providing rents to incumbent auditors can also intrigue negative stock market reaction to auditees due to the perceived dishonesty or low quality of their financial reporting . Firm-specific standard deviation of non-audit service fee over sample period is used as a proxy for non-audit service purchase variability 6, the lower standard deviation is, the more consistent non-audit service purchase behaviors is. The hypotheses related to non-audit service purchase level and its variability is summarized in the alternative form as follows: H3.a: Bank firms with high level of non-audit service purchase are likely to have: 1) more negative association between loan loss provision and Tier I capital; 2) more positive association between loan loss provision and Tier II capital; 3)more negative association between loan loss provision and earnings than firms with less non- audit service purchase H3.b: Bank firms with low variability of non-audit service purchase are more(less) likely to have 1)negative association between loan loss provision and Tier I capital; 2) positive association between loan loss provision and Tier II capital; 3)negative association between loan loss provision and earnings 6 Although the SEC (2003) prohibit registrants from purchasing financial information systems design and implementation services and internal audit outsourcing from incumbent auditor, this does not affect data consistency over sample period. Registrants may still purchase many types of non-audit services, including tax compliance and consulting, employee plan audits, consulting on accounting matters, merger and acquisition consulting, and consulting on new debt and equity issues. - 17 -
  19. 19. 2.5 Size matters It is also important and meaningful to investigate size effect under Basel Accord. Firms of different sizes have different capital and earnings management incentives. Manipulation behaviors of large firms are widely documented in prior papers (see Rangan, 1998; Myers and Skinner, 2000).This could be explained by higher pressure they face to meet or beat analysts' expectations since market punishes them more severely for loss or falling below expectations than small firms( Barton and Simko, 2002). On the other hand, large-size firms’ manipulation incentives could be constrained by huge reputation cost and litigation risk. Being caught of manipulation would substantially diminish their years of effort to establish their credibility and reputation social responsibility and high quality of financial information in business community. Their litigation risk is much higher than small firms as well (see Bonner et al, 1998; Kellogg, 1984; Lys and Watts, 1994; Stice, 1991). Besides reputation and litigation constraints, great bargaining power they possess can lower their manipulation incentives. Bishop (1996) argues that large banks could continually violate capital adequacy requirements without provoking regulatory intervention (“too big to fail” hypothesis). Similarly, current literature has opposing views on manipulations incentives of small bank firms as well. First of all, small firms’ performances are more volatile than their large size counterparts, thus they have higher manipulation demand to achieve smooth performance. Due to small production scale and lack of diversification, small firm usually suffer a larger degree of loss for the same level of adverse change in external market environment than large firms do. Besides, low audit efficiency and lack of necessary information induce extra difficulty for manipulation detection. Usually small banks have less sophisticated internal control systems and less competent internal auditors than large-size bank firms. On the other hand, small bank firms may subject to stricter oversight by federal regulators and market investors, suggesting discretionary behaviors are less likely. Based on above analysis, I do not have clear prior directional prediction - 18 -
  20. 20. of size impact on capital or earnings management incentives after 1991.The hypothesis stated in alternative form as: H4: Bank firms of small total assets are more(less) likely to have: 1) negative association between loan loss provision and Tier I capital; 2) positive association between loan loss provision and Tier II capital; 3) negative association between loan loss provision and earnings than large-size bank firms 3. Model Design and Specification Management manipulations are widely found and documented in the highly regulated banking industry. However, different from other industries, banks management does not have many private contract incentives, for example, bonus plans, debt agreements, cost of capital and other contracts. Smith and Watts (1986) report only 67% of banks have accounting-based bonus plans, while the percentage is as high as 91% in other unregulated industries, and cost of capital does not impact accounting choices much neither. Based on a sample of commercial banks, Moyer (1988) finds no association between accounting adjustments and dividend covenants. All the empirical evidence indicate private contracts incentives possibly do not influence bank manager’s accounting choices as much as they do in other industries, which makes the manipulation detection modeling more straightforward and efficient. The most recognized manipulation incentives in banking industry are regulatory capital and earnings (see Greenawalt and Sinkey, 1988; Moyer, 1990; Beatty et al., 1995; Collins et al, 1995). Capital managements are driven by capital adequacy requirements, which set frameworks on how banks and depository institutions must handle their capitals. Basically it requires the ratios of regulatory capital to highly standardized assets to be maintained above certain minimum level. Bank firms also face pressures from investors and regulatory institutions about their profit numbers and balance sheet appearance. Punishment of falling short of either regulatory capital or earnings targets can be very detrimental to the growth perspective of bank firms. The substantial cost induces - 19 -
  21. 21. management incentives, and both capital and earnings manipulation can be achieved via discretionary loan loss provision. Basic experimental model is designed based on above discussion. First, for the capital management incentive, Tier I capital and Tier II capital proxy are used (T1C, T2C).In the old capital regime setting, Tier II capital is not related loan loss provision. Basel capital rules shift loan loss reserve from Tier I capital to Tier II capital, by which Tier II capital becomes a new option of capital management under Basel Accord. Tier I capital is still related to loan loss provision, but it has totally different management mechanism from Tier II capital. Tier I and Tier II capital are therefore studied separately. Second, earnings manipulation incentive is represented by one real earning proxy--earnings before taxes and loan loss provision deflated by total assets (EBTP). If bank firms smooth earnings via loan loss provision, we expect to observe a positive relationship between loan loss provision and EBTP. In addition, in order to examine whether bank managers behavior differently when banks perform poorly or when there is a pure loss incurred, another variable is used. Negative earning before taxes and loan loss provision (LOSS) is added to capture the difference. Fourth, although loan loss reserve is included in Tier II capital under the new regime, it is limited up to 1.25% of risk-weighted assets. This encourages banks with low loan loss reserve levels to involve in capital management. The benefit of manipulation for banks with loan loss reserve exceed the upper bound is not maximized, and usually, banks with large amount of loan loss reserve have high capital level. The ratio of loan loss reserve before loan loss provision of current year to risk-weighted assets (LLR) is used to capture the significant impact of loan loss reserve level on capital manipulation. DLLP = β 0 + β 1T 1C + β 2T 2C + β 3 LLR + β 4 EBTP + β 5 LOSS + β 6 BigFive + β 7 LEVERAGE + ε (1) Where T1C Ratio of Tier I capital before loan loss provision to risk-weighted total assets T2C Ratio of Tier II capital before loan loss provision to risk-weighted total assets LLR Ratio of Loan Loss Reserve loan loss provision to risk-weighted total assets EBTP Earnings before taxes and loan loss provision/average total assets - 20 -
  22. 22. LOSS Negative earnings before taxes and loan loss provision/average total assets LEVERAG Ratio of total liability to average total assets Besides above basic incentive variables, two more additional variables are included. First, prior studies show that discretionary accruals are generally associated with leverage level (see DeFond and Jiambalvo 1994; DeAngelo et al. 1994; Becker et al. 1998).Although the findings are based on samples from industries other than banking, it is worthwhile to examine the relationship between leverage level and loan loss provision since leverage is also an important performance indictors for banks. To achieve this, total liability to total asset ratio (LEVERAGE) is included in the regression. Second, the different impact of Big-5 and non Big-5 auditors on bank management behaviors is considered as well. Becker et al (1998) and Francis et al (1999) conclude that Big-5 auditing firms usually report lower level of discretionary accruals than non- Big 5 firms while they report higher level of total accruals. Gore et al. (2001) also directly claim that non-Big 5 auditors allow more earnings management, and they do not find any significant statistical association between several manipulation proxies and fees charged by their Big-5 counterparts. The conservative behavior of Big-5 firms could possibly be explained by high litigation risk and adverse reputation effect they may face. Big auditors with substantial number of clients have “more to lose” if their reputation is ruined by helping or failing to report detected misbehaviors in a particular clients financial records (see DeAngelo, 1981; Reynolds and Francis, 2000). BigFive, a dummy variable which equals one if the auditor is one of the big five auditors, is used to test whether it is still true in the banking industry that Big 5 auditors are generally related to higher financial reporting qualities. This is a very interesting issue to investigate, because among all industries, only banking has extra capital targets to reach besides the popular earnings benchmarks. Furthermore, Tier I capital (the primary component of total capital) and earnings management incentive become consistent starting from the Basel Accord, and this, gives bank managers more incentive to “bribe” auditors by providing” bigger rent”. In other words, - 21 -
  23. 23. although Big 5 auditors have “more to lose” by hiding detected misbehaviors, they have “more to gain” in the banking industry at the same time. One common way to “bribe” auditors is non-audit service purchase. The impact of both the level (HNAF) and variety (VAR) of non-audit purchase on bank management manipulation mechanisms are tested as conditional variables, as they are defined in the hypothesis section. Moreover, size effect (SIZE) is also examined. These variables are added into the basic regression model as formula (2) demonstrated (uses HNAF as an illustration), to reflect the cross-sectional variations of banks’ earnings and capital manipulations as a function of the above three variables. As stated in the hypothesis development part, I expect firms purchase higher level of non-audit service to be more likely to manipulate their earnings and capital ratios upward to their desired level, compared to those firms with less non-audit service purchase. However, I do not have clear prior prediction of the impact of non-audit service purchase variability and size effect. DLLP = β 0 + β 1T 1C + β 2T 2C + β 3 LLR + β 4 EBTP + β 5 LOSS + β 6T 1C * HNAF + β 7T 2C * HNAF + β 8 LLR * HNAF + β 9 EBTP * HNAF + β 10 LOSS * HNAF + β11 Big 5 + β 12 LEVERAGE + ε (2) Same as Kim and Kross(1998) and Ahemad et al (1999), Tier I capital and Tier II capital are capitals after adjustment. All capital data download from databases are only the capital reported by the bank manager after possible loan loss provision manipulation, adjustment is needed in order to avoid mechanical link between dependent variable and capitals. However, our adjustments are made in different ways. I start from reported capitals in Y9-C report (Consolidated Financial Statements for Bank Holding Companies—FR Y-9C) instead of the capital ratios as they did. Adjusted Tier I capital ratio= [reported Tier I capital (BHCK8274) + (1- T)* LLP (BHCK 4230)]/total risk-weighted assets (item 62), and adjusted Tier II capital ratio= [reported Tier II capital (BHCK 8275)-LLR (BHCK5310)]/total risk-weighted assets (item 62), T is the tax rate. There are two things to be clarified about the capital ratios computation. First thing - 22 -
  24. 24. is about the tax rate. Y9-C does not report the tax rate for each firm in each specific fiscal year, only the total tax expense is presented. For the purpose of calculation, I follow Kim and Kross (1998) and assume a universal tax rate of 34%. To get more accurate results, I plan to use item 8 (income before tax and extraordinary items) and item 9(applicable income tax) in the income statement to calculate the yearly tax rate for each firm. However, I expect the result to be similar. Second, according to Basel Accord, bank firms can choose to deduct the amount LLR exceeding 1.25% of risk –weighted assets from denominator when calculate Tier I capital or Tier II capital ratio. The denominator reported in Y9-C is actually the total risk-weighted assets (item 62) after possible LLR adjustments. That is, denominators are also need to be adjusted if a bank’s LLR is larger than 1.25% of risk-weighted assets after possible LLP discretion and the firm chooses to use this to reduce denominator in order to inflate capital ratios. However, after careful scrutiny in the test sample, I find LLR before loan loss provision in this sample are mostly lower than the upper limit, specifically, the mean is 1.1% and median is 0.09% of risk-weighted assets. DLLP in the above two regressions is discretionary loan loss provisions. Compare to financial reporting quality proxies in other non-banking industries, loan loss provision better satisfies two critical criteria which make it a good measure of manipulation behaviors. First, it is very sensitive to hypothesized discretionary behaviors, in particular, earnings and capital managements which are discussed in section two. Second, nondiscretionary components of loan loss provision are readily developed in banking context. As researchers can rely on generally accepted accounting principles (GAAP) to understand what fundamentals should be reflected in the accounts in absence of management manipulation, they can make a reasonably accurate prediction about loan loss provision realizations which are not caused by its nondiscretionary components. These non- discretionary loan loss provision components should reflect sound credit risk assessment and loan portfolio valuation. Based on this, I follow Beatty et al (2002) to regress loan loss provision on a series of loan portfolio characteristics variables identified under GAAP: - 23 -
  25. 25. LOSS it = α it + β 0 LASSETit + β1 ∆NPLit + β 2 LLRit + β 3 LOANRit + β 4 LOANC it + β 5 LOANDit + β 6 LOANAit + β 7 LOANI it + β 8 LOANFit + ε it (3) LOSS = loan loss provision deflated by the average of beginning and ending total loans; Change in nonperforming loans deflated by the average of beginning and ending = total loans; natural log of total asset; LASSET = loan loss reserve deflated by the total loans at the beginning of the year; loans secured by real estate deflated by total loans; LLR = commercial and industrial loans deflated by total loans; loans to depository institutions deflated by total loans; LOANR = loans to finance agricultural production deflated by total loans; loans to individuals deflated by total loans; LOANC = loans to foreign government deflated by total loans The size effect, region effect and specific function of loans are controlled in the regression. I pool across all bank-years with available data, and the regression residuals are used as discretionary loan loss provision (DLLP), the proxy for financial information quality in our sample. 4. Sample and Data Description I use 1609 bank holding firm-year observations over the period of 2001-2005. Each firm has at least four years data. All firms are with the SIC code 6021 and 6022, and have December 31 Fiscal year-end. Bank firms with Merger and Acquisitions activities over the sample period are removed since these events increase expected demands for both audit and consulting services. Gunther and Moore (2003) investigated regulator mandated revisions instances in loan loss provisions and found out that only six in their study involve banks with over $500 million in total assets. Bank firms in our sample all have total assets over $500 million so that the loan loss provision determination and analysis by the management are tacitly allowed by regulators. Besides, to be included in the sample, banks firms must have complete data from following data sources as well: - 24 -
  26. 26. • CFRB of FRBC7 : loan portfolio variables needed for loan loss provision regression for banking holding firms • EDGAR8: DEF 14A proxy statement for auditor fee matrix data and 10-k for non- performing loan data • Compuastat: all other control variables According to SEC rule (2000), Section II.C.5, firms are required to disclose audit service fee, financial information system design and implementation fees (IS in short) 9 and “All other fees” (Exhibit 1). Sum of IS fee and all other fees are considered as non-audit service fee. Descriptive statistics in Table 1 indicate that average (median) non-audit fee ratio is 29.27 %( 26.31%), much lower than those of audit service fee ratio of 70.73 %%( 73.69%). This is different from extant literature findings, which show that the proportion of non-audit service makes up more than 50% of total fee since late 1990s.This maybe is caused by stringent regulatory and monitoring systems specific to the banking industry. Panel B of Table 1 shows that, three components of non-audit service are evenly distributed, that is, average amount of audit-related fee, tax service fee and all other fee is around 10% of total fee respectively. This is also different from other industries. Generally, some non-audit service are less recurring than other single engagement, for example, merger and acquisition service and consulting on new debt and equity issues, and some are more recurring, for example, audit-related service, and tax service. Especially in recent years, more firms purchase a high portion of tax service as non-audit service, aiming to save tax expenses via lower taxable earnings. Table 2 reports descriptive statistics comparison of fees composition between Big5 auditors and non-Big5 auditors (All fees are in thousands of dollars). Total number of observations is 828 for Big5 firms and 781 for non-Big5 firms. Therefore, our results will not be biased by sample construction bias. The average total fee charged by the Big4 auditors is 7 Federal Reserve Bank website of Chicago 8 EDGAR: SEC Filings and Forms 9 Required by Sarbanes-Oxley Act of 2002(July 30, 2002), audit firms are prohibited from providing services such as financial information system implementation and design, internal auditing, and a number of other services - 25 -
  27. 27. 2083.18 thousands, much higher than that charged by non-Big5 auditors (167.18 thousands). Possible explanation would be that big-five firms charge fee premiums for non-audit service as well as audit service based on their recognized industry specializations, high audit quality and general brand name. Non-audit fee ratio of non-Big5 firms (28.45%) is slightly lower than that of Big-five firms (30.04%), but the magnitude of difference is not significant. However, they are far larger than the previous level (10%) reported by SEC (2000)10. The substantial increase of non- audit service as an important revenue source of auditor firms poses threats to auditor independence. Table 3 presents time-series analysis of audit fees and ratios from year 2001 to year 2005. The median data of full sample, Big-Five firm sample and Non-Big-Five firm sample are reported in Panel A, B and C respectively. Generally, non-audit service fee ratio decreases over the years from 2001 to 2005, and the decrease becomes substantial starting from 2003. I suspect this is not caused by the effect of SEC 2000 detailed audit fee disclosure rule, as evidenced by significant relations between non-audit service fee and discretionary loan loss provision in results part. On the contrary, it may due to huge increase of audit fee caused by the Sarbanes-Oxley Act of 2002. SOA expanded SEC 2000 rule and requires companies to include any fees for services performed to fulfill the accountant’s responsibility under GAAS in the “audit fees” category, instead of just the fees paid for audits and quarterly reviews. Besides that, SOA removed quite many services from “non-audit service” category, for example, financial information system implementation and design, and a number of other services. Therefore our time-series results remind researchers to interpret the non-audit service fee ratio decrease with caution. It may not necessary due to the effectiveness of SEC 2000 rule although I can not fully exclude its influence. Loan is a major asset of banks. The total loan to total asset ratio in our sample has a mean (median) of 66.28 %( 67.45%). Untabulated table shows that mean (median) ratio of loan loss 10 In SEC (2000) report, the 1999 data shows that non-audit fee is only 10% of total fee, and only 75% of firms purchase non-audit service. - 26 -
  28. 28. provision to average total loan is 0.39 %(0.29%), and mean (median) ratio of loan loss provision to earnings before loan loss provision and tax is as high as 15.85 %(11.05%). Thus, loan loss provision is a substantially important accrual for banks. Table 4 presents descriptive statistics of regression variables for 1609 bank holding firm-year observations from year 2001 to year 2005. All bank firms file Y-9C reports with the Federal Reserve and disclose audit data in EDGER. On average, the reported Tier I capital before loan loss provision is 12.429%, much higher than the minimum 4% level required under the 1991 new capital regulation. This suggests that bank firms in our sample are well-capitalized. The means of Tier II capital and loan loss reserve ratios are 1.260% and 1.10%respectivley. Moreover, mean ratio of earnings before tax and loan loss provision to total asset (EBTP) is 6.9% and the mean return on asset (ROA) is 1.1%. These magnitudes are consistent with what documented in prior studies in literature. 5. Empirical Results Table 5 presents evidences of new earnings and capital management mechanisms of bank firms under Basel Accord. Consistent with the basic hypothesis that loan loss provision decreases Tier I capital under the new regime instead of increasing as it does before 1991, I find a significantly positive coefficient of TIC(0.0003, two-tailed p- vale 0.00). That is, firms with low Tier I capital would like to decrease loan loss provision to reach capital adequacy requirement. This finding is different from Ahemad et al (1999), which find a negative coefficient on Tier I capital (CAPB, pg12).I think this discrepancy is caused by sample difference. Ahemad et al (1999)‘s sample period is from 1986 to 1995, which covers both regimes before and after Basel Accord. However, the interaction term CAPB*REG (REG equals one if the data is from the new capital regime) is significantly positive, verified the results in this paper in an indirect manner. Furthermore, Kim and Kross(1998) use a test sample similar to Ahemad et al (1999) with sample period of 1985 to 1992, they do find that banks with low capital ratios have a lower loan loss provision under Basel Accord regime. Although many papers investigated the impact of capital - 27 -
  29. 29. adequacy regulation changes, this paper is the first one using all-new-regime data to provide direct bank manipulations mechanism evidences under Basel Accord. Basel Accord changes have impact on Tier II capital as well. Under the new regime, loan loss reserve is shift from Tier I capital to Tier II capital, that is, one unit increase of loan loss provision can increase the Tier II capital by one unit. This new regulation manifests itself by a significant negative coefficient of T2C (-0.0002, two-tailed p-value, 0.00) in table 5. Therefore, different from loan loss provision’s negative effect on Tier I capital, firms are more likely to manipulate loan loss provision upward when Tier II capital is at low level. However, loan loss reserve in Tier II capital is restricted to an upper bound. Under Basel Accord, loan loss reserve includable in Tier I capital must be lower than 1.25% of risk-weighted total assets. Therefore, banks with loan loss reserve under that threshold would have more capital management incentive than firms with high loan loss reserve. LLR variable, ratio of loan loss reserve before loan loss provision at year end is used to capture different manipulation mechanisms for firms with different loan loss reserve level. The result is consistent with the above hypothesis. Specifically, LLR has a negative coefficient, and significant at 5%level (-0.0102, two-tailed p-value, 0.00). Consistent with literature evidence, earning management behavior also manifests itself by a significant positive coefficient of EBTP (0.0003, two-tailed p-value, 0.01), suggesting that firms with poor earnings performance prefer to decrease loan loss provision. This could be easily explained since loan loss provision works as a pure expense in the income statement to decrease the taxable income under Basel Accord. The variable LOSS, however, does not have explanatory power. It could be mostly likely due to the specific banking industry context of this paper. Under common circumstances, banks firms are less likely to have negative earnings than firms in other industries. After carefully examination of the sample data, I indeed find very few firms with loss. Coefficient of Big five is significantly negative (-0.0004, two-tailed p-value, 0.02), indicating that litigation risk and adverse reputation effect cause the conservative behavior of Big-5 firms. Large auditors with substantial number of clients have “more to lose” if reputation is ruined by helping - 28 -
  30. 30. or failing to report detected misbehaviors in a particular clients financial records (see DeAngelo, 1981; Reynolds and Francis, 2000).Furthermore, different from prior studies (see DeFond and Jiambalvo 1994; DeAngelo et al. 1994; Becker et al. 1998), I do not find significant association between leverage level and loan loss provision. Table 6 presents evidences of cross-sectional variation of banks’ manipulation behaviors in particular, as a function of high non-audit service purchase. As we know, many literature works provide evidences that non-audit service is associated with observable difference in earnings quality proxies (see DeAngelo 1981; Beck et al. 1988; Magee and Tseng 1990; Francis and Ke, 2001; Frankel et al 2002; DeFond et al. 2002; Ashbaugh et al, 2003), while loan loss provision is one widely used measure for financial reporting quality in banking industry. This motivate this paper to investigation the empirical association between non-audit service and loan loss provision, conditional on different loan loss provision management incentives. HNAF, a dummy variable which equals one if the Non-audit fee to total fee ratio is above the median level is used. Table 6 shows that T1C *HNAF is significantly positive (0.0002, two-tailed p-value 0.00), and T2C *HNAF is negative, significant at 5% level (-0.0003, two-tailed p-value 0.04).The interaction terms have the same signs as those of TIC and T2C, indicating that high non-audit service fee strengthen the capital management incentives. In a word, high level of non-audit service purchase give bank firms more incentive to do manipulations to reach desired results, in the expected direction. However, LLR* HNAF and EBTP* HNAF are not significant. Besides non-audit service fee level, the variability of non-audit service purchase is also expected to reflect the economic bonding between auditors and bank firms. Firms purchase non- audit service in large amount consistently must have different manipulation incentives from those firms who purchase little in magnitude or those who purchase sparsely. Thus it is another aspect needed to be take into account when study banks’ manipulation behaviors under Basel Accord. Table 7 presents the impact of non-audit service fee variability on the association between banks managers’ manipulation incentives and loan loss provision (LLP). Two different measures (VAR) - 29 -
  31. 31. are used to capture the nature of non-audit service fee variability in terms of both magnitude and frequency. In model (1), VAR is defined as a dummy variable, equal to 1 if the standard deviation of a firm’s non-audit service fee is below the sample median; in model (2), as an alternative measure for robustness check purpose, it is defined by standard deviation rank, equal to 1 if the standard deviation of the non-audit service fee ratio is in the highest rank deciles, and 10 if it is in the lowest rank deciles in the sample. The coefficients of T1C* VAR and EBTP*VAR under both models are significant negative at 5%level, while T2C* VAR coefficients are positive and statistically significant; all are opposite to the signs in the basic model. This suggests that firms purchase non-audit services consistently are less likely to manipulate capital and earnings upward via loan loss provision adjustments than those firms who purchased sparsely. This could be possibly due to high litigation risk and negative market reaction caused by continuous non-audit service purchase. The sample period in this paper starts from 2001, the year when auditor independence became a big consideration and many legislative interventions come out aiming to restrict non-audit service supply. Consistent and regular non-audit service provision poses more litigation risk to auditors when it is perceived as a symbol of impaired independence. Furthermore the expected monitoring value of audit is assumed lowered by the market; therefore, continuous providing rents to incumbent auditors via non-audit service purchase can also result in perception of dishonesty or low quality of financial reporting of auditees. As a result, market reacts very negatively, whenever they “perceive “low audit quality (JERE .R, 2006). Size effect on banks’ manipulation behavior under Basel Accord in 1991 is investigated in table 8. SIZE is a dummy variable, equals to 1 if total asset of a bank firm is below the sample median level, and 0 otherwise. Size effect on Tier 1 capital and Tier 2 capital are both significant, and in the expected direction. Coefficient of interaction term T1C *SIZE is positive (0.0004, two- tailed p-value 0.00), indicating that small firms have stronger association between Tier I Capital and discretionary loan loss provision. Size has reinforcing effect on Tier II capital as well, showing a significantly negative coefficient of the interaction term T2C *SIZE (-0.0013, two- - 30 -
  32. 32. tailed p-value 0.00). All these evidences indicate that, compare to large-size firms, small firms have stronger capital management incentives via loan loss provision manipulation. Stinson (1993) and Bishop (1996) bring up a ‘too big to fail’ hypothesis, arguing that regulators are reluctant to intervene in the operations of large banks. Therefore, cost of falling short of capital adequacy requirement is low and big firms do not bother to manipulate. Besides these, large-size firms’ manipulation incentives could be constrained by huge reputation cost and litigation risk, as Kellogg (1984), Stice( 1991) and Bonner et al(1998) find out. On the other hand, this could be explained by the fact that small-size firms have more manipulation incentives by nature. First, their performances are far more volatile compared to large firms. Small firms face same earnings stress and capital requirement pressures from both market and regulatory institutions as large firms do, however, their performance suffer a larger degree of variability for the same level of external market factor change. Therefore, small firms have high manipulation demand to achieve performance smoothing. Secondly, small banks have less sophisticated internal control systems and less competent internal auditors than large-size bank firms. Lack of necessary private information and low efficiency increase the difficulties of manipulation detection, which encourage bank firms to manipulate earnings and capitals to the desired level. Greeenawalt and Sinkey(1988) document that small regional firms are more likely to engage in earning management. However, this paper does not find similar evidence. As robustness check, the impact of interaction between HNAF and VAR, HNAF and SIZE are investigated in table 9 and table 10 respectively. Table 9 presents the impact of both level and consistency of non-audit service purchase on bank firms’ manipulation incentives via loan loss provision (LLP) under Basel Accord. Similar to results in table 7, coefficient of EBTP*HNAF*VAR is significantly negative (-0.0009, two-tailed p-value 0.01). That is, probably due to high litigation and detection risk, and negative market reaction caused by perceived low quality financial reporting, firms purchase non-audit service consistently and regularly are less likely to manipulate earnings than those firms who purchased irregularly. Another variable - 31 -
  33. 33. significant under HNAF and VAR interaction is loan loss reserve. However, coefficient of LLR*HNAF*VAR is significantly negative (-0.0617, two-tailed p-value 0.00), suggesting that non-audit service purchase level dominant the effect here, high level and high frequency of non- audit service purchase give bank firms more incentive to manipulate loan loss reserve upward via loan loss provision. The impact of interaction between HNAF and SIZE is examined in table 10 11. Although T1C*HNAF*SIZE is not significant, it has the sign consistent with results in table 8. T2C*HNAF*SIZE is negative and significant at 5% level (-0.0008, two-tailed p-value 0.00), indicating that, compare to large size firms with same level of non-audit service fee, small firms are more likely to manipulate loan loss provision upward to reach the capital requirement target when Tier II capital is low. Firms have discretion to choose auditors and decide the timing and magnitude of non-audit service purchase themselves. This self –selection system reflect a lot about the association between non-audit service purchase and agency incentives, that is, different management incentives motivate and decide non-audit service purchase amount. Consistent with what discussed in hypothesis development part, small firms has higher manipulation demand than their counterpart of larger scale, therefore, they deliberately choose to purchase high level of non- audit service. 6. Conclusion This paper empirically investigate new capital and earnings management mechanisms under Basel Accord in US banking industry, and its cross-sectional variations as a functions of both level and variability of non-audit service purchase, and total assets. Overall, I find evidence that: (i) Tier I capital is positively related to loan loss provision, that is, bank firms would like to manipulate capital ratios up by decrease loan loss provision when Tier I capital is low. This is different from literature papers which document a negative 11 LOSS*HNAF*SIZE variable is deleted from the regression analysis by the statistic software since the variables are constants or have missing correlations - 32 -
  34. 34. association. The discrepancy is caused by capital adequacy requirement change under Basel Accord since 1991. Loan loss reserve is no longer a component of Tier I capital and loan loss provision purely has negative impact on it as a deduction to retained earnings. Moreover, loan loss provision is negatively related to Tier II capital and loan loss reserve to risk-weighted total assets ratio. Bank firms are more likely to increase loan loss provision to manipulate Tier II capital upward, and this incentive is especially stronger when loan loss reserve is at low level. All these findings enhance our understanding of capital management mechanisms under Basel Accord. (ii) In addition, consistent with prior literature, loan loss provision decreases income before tax, thus firms would like to decrease loan loss provisions for earnings management purpose. (iii) Compared to large bank firms, small firms have stronger capital management incentive via loan loss provision.( iv) Same as the evidences from other industries, high level of non-audit service purchase give bank firms more incentive of earnings and capital management However, regular and consistent non-audit service purchase suppress bank firms’ manipulation actions. This is because continuous providing rent to auditors does not only increase detection possibility and pose high litigation risk to auditors, perception of impaired honesty and low financial reporting quality by the investors also triggers negative market reaction to bank firms. The primary focus of this paper is the capital management and loan loss provision under the new capital regime after 1991 and its cross-sectional variations related to size and non-audit service properties. It does not discuss whether the auditor independence is impaired. This stand- alone marginal analysis can not tell us much about that in isolation with comprehensive institutional settings and audit contracting incentives investigation. Evidence of factual impairments is very limited in the literature due to the unobservability of auditor independence. Advanced and rigorous models which can probe subjective issues are needed. However, the documented evidences of association between non-audit service and loan loss provision in this paper do provide directional references for further auditor independence research in this specific banking industry. Furthermore, this paper enriches the literature in both non-audit service and - 33 -
  35. 35. loan loss provision, and can facilitate well-informed policy making by regulators to improve regulators’ supervision and monitoring processes. Limitation of this paper is that these industry- specific evidences may have difficulty to be generalized to other industries since banking industry has lots of unique features which are substantially different from others. - 34 -
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  37. 37. Dechow P, Sloan,R., Sweeney,A., 1995. Detecting earnings management .The Accounting Review 70,193-225 DeFond M., K. Raghunandan, K. Subramanyam., 2002. Do non-audit service fees impair auditor independence? Evidence from going-concern audit opinions. Journal of Accounting Research 40: 1247–1274. DeFond M, Park,C., 1997. Smoothing income in anticipation of future earnings, Journal of Accounting and Economics 23, 115-139 DeAngelo, L., 1981. Auditor independence,“Low Balling” and disclosure regulation. Journal of Accounting and Economics (August): 113–127. DeAngelo, L., 1981. Auditor size and audit quality. Journal of Accounting and Economics 3:183– 199. Francis, B. Ke., 2001. Do non-audit services compromise auditor independence? Working paper, University of Missouri and Pennsylvania State University. Fraincis J., Maydew. E., Sparks .H.C., 1999. The role of big-6 auditors in the credible reporting of accruals. Auditing: A Journal of Practice and Theory 18, 17-34 Frankel, R., M. Johnson., K. Nelson., 2002. The relation between auditors’ fees for nonaudit services and earnings management. The Accounting Review 77: 71–105. Firth, M., 1997. The provision of nonaudit services by accounting firms to their audit clients. Contemporary Accounting Research 14 (summer): 1–21. Gunther, J.W., R.R. Moore, 2003. Loss underreporting and the auditing role of bank exams, Journal of Financial Intermediation 12, 153-178 Gore, P., P. F. Pope, A. K. Singh., 2001. Non-audit services, auditor independence, and earnings management. Working Paper, Lancaster University. Greenawalt, M., Sinkey, 1988. Bank loan loss provisions and the income smoothing hypothesis: An empirical analysis, 1976-1984. Journal of Financial Services Research 1, 301-318. Hansen, S. C., J. S. Watts. 1997. Two models of the auditor-client interaction: Tests with United Kingdom data. Contemporary Accounting Research 14: 23–50. Healy, P., 1985. The effect of bonus schemes on accounting decisions. Journal of Accounting and Economics 7, 85-107 Kasznik, R., 1999. On the association between voluntary disclosure and earnings management. Journal of Accounting Research 37: 57–81. Kellogg, R., 1984. Accounting activities, securities prices, and class action lawsuit. Journal of Accounting and Economics 6,185-204 Kinney, W., R. Libby., 2002. Discussion of the relation between fees for non-audit services and earnings management. The Accounting Review 77 (Supplement): 107–114. - 36 -
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  39. 39. Exhibit 1: The “rule” and the “policy” The exhibit reports major regulatory requirement related to non-audit service after year 2000. After implementation of Sarbanes-Oxley Act, SEC filed “Final Rule: Revision of the Commission's Auditor Independence Requirements” (the “rule”) [File No. S7-13-00] in November 2000, requiring firms, starting from February 5, 2001, to disclose: 1) audit fees; 2) IS fees; 3) audit-related fees; 4) tax fees; and 5) all other fees. They are described in Audit and Non- Audit Services Pre-Approval Policy (the “policy”) as follows: • Audit services include the annual financial statement audit (including required quarterly reviews), subsidiary audits, and other procedures required to be performed by the independent auditor to be able to form an opinion on the Company's consolidated financial statements. These other procedures include information systems and procedural reviews and testing performed in order to understand and place reliance on the systems of internal control, and consultations relating to the audit or quarterly review. Audit services also include the attestation engagement for the independent auditor's report on management's report on internal controls for financial reporting, when required. • IS services include financial information system design and implementation. • Audit-related services include, among others, due diligence services pertaining to potential business acquisitions/dispositions; accounting consultations related to accounting, financial reporting or disclosure matters not classified as "Audit services"; assistance with understanding and implementing new accounting and financial reporting guidance from rulemaking authorities; financial audits of employee benefit plans; agreed- upon or expanded audit procedures related to accounting and/or billing records required to respond to or comply with financial, accounting or regulatory reporting matters; and assistance with internal control reporting requirements. • Tax services include tax compliance, tax planning and tax advice • All Other services include permissible non-audit services12 that are routine and recurring services, would not impair the independence of the auditor and are consistent with the SEC's rules on auditor independence 12 Prohibited Non-Audit Services in SEC filed Final Rule include: bookkeeping or other services related to the accounting records or financial statements of the audit client; financial information systems design and implementation; appraisal or valuation services and fairness opinions; actuarial services; internal audit services; management functions; human resources; broker-dealer, investment adviser or investment banking services; legal service; expert services unrelated to the audit - 38 -
  40. 40. Exhibit 2: Non-audit service research literature evidence The exhibit presents a brief summary of mixed results of the association between non-audit service provision and auditor independence in the literature. Basically the literature reveals three types of relation: positive, negative and no association. Most papers find no empirical evidence that non-audit service provision impair auditor independence. Relation between Non-Audit Service and Prior Papers Number Earnings Quality Positive Association Dee et al.(2002) 3 Ferguson et al.(2003) Frankel et al.(2002) 1 --only for income-decreasing Ashbaugh et al.(2003) accruals 1 --only for smallest firm groups Chung and Kalllapur (2003) 1 --only for non-big five firms Gore et al.(2001) 1 --only for firms with poor corporate Larcker and Richardson (2004) governance Negative Association Antle et al.(2002) Firth (2002) 3 SharmaandSidhu (2001) No Association Pringle Buchman (1996) Bajaj et al. (2003) Chung and Kalllapur (2003) Craswell (1999) Craswell et al.(2002) DeFond et al. (2002) 12 Kinney et al.(2003) Krishnan (2003) Li et al.(2003) Raghunandan et al.(2003) Ruddock et al.(2003) Larcker and Richardson.(2004) - 39 -
  41. 41. Table 1: Descriptive Statistics of Auditor Fees Disclosed in Proxy Statements in Banking Holdings Companies (2001-2005) This table reports descriptive statistics of auditor fees disclosed in proxy statement for 1609 bank holding firm-year observations from year 2001 to year 2005.Panel A presents the distribution of mandatory disclosure by SEC 2000, Section II. The components Non-Audit fee in Panel A are described in Panel B: audit-related fee, tax fee, the financial information system design and implementation fee (IS) and all other Advisory fee. All other advisory service is general consulting service, and information technology consulting for systems not associated with the financial statements. Please refer to Exhibit 1 for fee variables definition. All fees are in thousands of dollars. Standard First Third Variable Mean Deviation Quartile Median Quartile Minimum Maximum Panel A: Mandatory Disclosure of Fee Data Audit 665.20 2916.91 75.50 135.20 345.40 0.07 55000.00 Audit/Total 70.73% 18.32% 59.94% 73.69% 84.37% 6.36% 100.00% NonAudit 487.96 2521.77 22.00 49.47 131.18 0.00 58700.00 NonAudit/Total 29.27% 18.32% 15.63% 26.31% 40.06% 0.00% 93.64% IS 1.00 37.20 0.00 0.00 0.00 0.00 1491.00 IS/Total 0.07% 1.41% 0.00% 0.00% 0.00% 0.00% 43.60% Total Fees 1153.17 5030.73 110.59 202.96 521.18 0.09 74200.00 Panel B: Voluntary Disclosure of Fee Data Audit-Related 215.89 878.19 10.64 23.50 62.73 0.00 9900.00 Audit-Related/Total 9.50% 11.15% 0.00% 6.30% 14.20% 0.00% 72.37% Tax 271.25 1393.00 9.00 20.78 66.75 0.00 15300.00 Tax/Total 10.10% 10.91% 0.00% 7.56% 14.31% 0.00% 74.77% All Other 240.74 1767.31 6.22 23.79 73.40 0.00 35300.00 All Other/Total 9.59% 16.88% 0.00% 0.05% 12.25% 0.00% 93.64% - 40 -

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