Provisions for loans are crucial for the stability of banks as they serve as a safety "buffer" to mitigate the risks of defaults and systemic risks in the banking sector. Loan loss provisions are typically divided into two components: mandatory and discretionary. Mandatory provisions are based on assessments of potential future credit losses, while discretionary provisions largely depend on the evaluations made by bank managers…

Provisions for loans are crucial for the stability of banks as they serve as a safety "buffer" to mitigate the risks of defaults and systemic risks in the banking sector. Loan loss provisions are typically divided into two components: mandatory and discretionary. Mandatory provisions are based on assessments of potential future credit losses, while discretionary provisions largely depend on the evaluations made by bank managers. Consequently, discretionary loan loss provisions can become a tool for bank managers to manipulate financial reporting to meet capital management goals, reduce income volatility, and signal to investors. When banks manipulate financial statements through provisions, it can lead to information distortion for shareholders, banking regulators, and the market, especially when the economy experiences instability.

Using data from U.S. banks from Q1 2020 to Q2 2021, this study explores the exogenous nature of the COVID-19 pandemic as a context to examine whether banks exploited their decision-making authority regarding loan provisions to cope with the crisis, and to what extent. The COVID-19 pandemic represented an unprecedented shock, completely unforeseen and beyond the control of all economic agents, including banks.

Using Provisions to Manipulate Financial Reporting

Using a difference-in-difference (DiD) model, the research findings indicate that the behavior of using provisions to manipulate financial reporting is more prevalent among banks that suffered significant losses due to the COVID-19 pandemic. The results also show that the accounting information of banks became less transparent, or even misleading, for investors during the crisis. Furthermore, during the pandemic, banks increasingly tended to manipulate financial statements to adjust earnings, provide information to investors, and manage their capital requirements. However, larger banks and those with better capitalization were less likely to manipulate their financial reports. The study also found evidence that banks with a higher ratio of non-performing loans to total loan portfolios tended to manipulate their financial reporting more often.

Governance Implications

Banking regulators need to ensure compliance, safety, and soundness of banks by enforcing sound accounting principles and additional supervisory standards to limit the manipulation of financial reporting, especially during crises. Such accounting disciplines and legal requirements will help minimize financial reporting manipulation and enhance transparency within the banking sector. These measures could also strengthen the resilience of banks under adverse economic conditions. Additionally, policymakers should pay attention to disclosure standards to clarify the flow and use of capital by commercial banks. This will help regulatory authorities understand the effectiveness of commercial banks in complying with regulations and enable investors to assess the actual financial situation of these banks.

>>> VNU UNIVERSITY OF ECONOMICS AND BUSINESS
Dr. Nguyễn Phú Hà 
Dr. Lưu Ngọc Hiệp 
Ms. Cù Nguyễn Hà Trang 
Dr. Nguyễn Thị Phương Anh 
Nguyễn Trâm Anh, Institute of Economics and Strategic Management