Journal of Business Research 58 (2005) 312 – 320

Determinants of signaling by banks through loan loss provisions

Kiridaran Kanagaretnama, Gerald J. Lobob,*, Dong-Hoon Yangc
a
DeGroote School of Business, McMaster University, Hamilton, ON, Canada L8S 4M4
b
Whitman School of Management, Syracuse University, Syracuse, NY 13244, USA
c
School of Business, Information and Communications University, Taejon, Korea
Received 10 April 2001; accepted 3 June 2003

Abstract

This study investigates whether bank managers use their discretion in estimating loan loss provisions (LLP) to convey information about
their banks’ future prospects. Bank managers’ propensities to signal their private information vary cross sectionally because they face
different conditions and have different incentives. This study hypothesizes that the propensity to signal varies negatively with bank size and
positively with earnings variability, future investment opportunities, and degree of income smoothing. The empirical evidence supports these
predictions. It suggests that the propensity to signal is positively related to the degree of information asymmetry and that bank managers
attenuate perceived undervaluation of their banks by communicating their private information about their banks’ favorable future prospects.
D 2003 Elsevier Inc. All rights reserved.

Keywords: Signaling; Loan loss provision; Earnings variability; Investment opportunity set; Income smoothing

1. Introduction The need for signaling arises when managers with

Accounting principles for commercial banks require that
losses of loan principal that are probable and reasonably
estimable be recorded as loan loss provisions (LLP). This
recognition of provisions for loan losses results in an
increase in loan loss allowance and a reduction in current
net income. LLP is the expense representing management’s
estimate of the year’s net change in probable loan losses.
Bank managers have superior information relative to invest-
ors and other stakeholders regarding default risks inherent in
their loan portfolios; consequently, they can use that infor-
mation for estimating the LLP in each period. Additionally,
because bank managers have latitude in using their judg-
ment to estimate the LLP, they can exercise discretion over
the timing of recognition of certain loan losses. This paper
investigates (1) whether bank managers’ discretionary deci-
sions over LLP signal information about future operating
results and (2) whether cross-sectional differences in the
propensity to signal are related to certain bank-specific
economic characteristics. Prior research on this topic has
not addressed the latter issue.
* Corresponding author. Tel.: +1-315-443-3583; fax: +1-315-443-
5457.
E-mail address: gjlobo@som.syr.edu (G.J. Lobo).
information indicating that bank values are larger than those
assessed by the market desire to have them revised upward.
One approach to doing so is to indicate that the bank is
strong enough to absorb future potential losses by increasing
the LLP. Beaver et al. (1989) suggest that an increase in LLP
can indicate that ‘‘management perceives the earnings
power of the bank to be sufficiently strong that it can
withstand a ‘hit to earnings’ in the form of additional loan
loss provisions.’’ Implicit in their reasoning is that the
increase in LLP conveys a ‘‘good news’’ signal about the
strength of a bank’s future earnings. However, an increase in
LLP can also be viewed as bad news, especially if it is not
accompanied by other, more timely indicators of loan
default because LLP will then serve as the primary source
of information on loan default. Banks generally disclose
information on the change in nonperforming loans, which is
an important indicator of loan default. By controlling for
timely indicators of loan default such as change in nonper-
forming loans, loan loss allowance and loan charge-offs,
any excess LLP will contain only the ‘‘good news’’ com-
ponent (Liu and Ryan, 1995; Wahlen, 1994).
Signaling theory indicates that management’s primary
motivation for signaling is to address the adverse selection
problem (Akerlof, 1970) and that the credibility of the signal
is positively related to its cost. To be credible for strong

0148-2963/$ – see front matter D 2003 Elsevier Inc. All rights reserved.
doi:10.1016/j.jbusres.2003.06.002
 K. Kanagaretnam et al. / Journal of Business Research 58 (2005) 312–320
banks, the cost of a false signal must be sufficiently high for
banks that are not expected to perform well. In the case of
LLP, poorly performing banks (i.e., banks with low earn-
ings) will report even lower earnings if they increase LLP.
This, in turn, will increase the probability that they will be
audited by bank regulatory agencies and that the FDIC will
increase their insurance premiums. Furthermore, since man-
agement’s incentive compensation is often based on
reported earnings, an increase in LLP will reduce reported
earnings and result in lower management compensation.
The increased probability of regulatory scrutiny along with
the reduction in management compensation that could result
from false signaling through increasing LLP suggest that
there are strong disincentives for managers of poor banks to
engage in false signaling.
Another disincentive for poor-performing banks to signal
falsely by increasing LLP is reputation cost. Our study
analyzes 78 large U.S. bank holding companies that have
been in business for a long time. These banks are likely to
place a high value on the credibility of their actions in the
financial community and, consequently, are unlikely to risk
losing their credibility in exchange for potential short-term
gains that may result from false signaling.
Several studies hypothesize and find that bank managers
use discretionary components of provisions to signal their
private information about future prospects of banks. Beaver
et al. (1989) recognize that investors interpret an unexpected
increase in LLP as a signal of a bank’s financial strength.
Scholes et al. (1990) suggest that bank managers can lower
their cost of capital by exercising discretion over LLP to
convey their private information to investors. Other studies
(Grammatikos and Saunders, 1990; Musumeci and Sinkey,
1990; Elliott et al., 1991; Griffin and Wallach, 1991)
demonstrate that the capital market responded positively
to banks’ increases in LLP in response to less developed
countries’ debt payment suspensions. They attribute this
finding to investors interpreting the increase in LLP posi-
tively because it signals a bank’s intention and ability to
resolve its problem debt situation.
Wahlen (1994) offers evidence that bank managers in-
crease the discretionary component of current LLP when
future cash flow prospects improve. Beaver and Engel
(1996) provide additional evidence of positive effects of
discretionary LLP on stock price, which is consistent with
Wahlen’s (1994) findings. Liu et al. (1997) as well document
a positive market reaction to the unexpected increase in LLP,
but only for banks with low regulatory capital levels (‘‘at
risk’’ banks) in the fourth quarter. More recently, Kanagar-
etnam et al. (2003) find that managers of undervalued banks
use LLP to signal their banks’ future earnings prospects. In
contrast to the aforementioned empirical findings, Ahmed et
al. (1999) find no support for the signaling hypothesis.
To date, however, economic factors affecting the propen-
sity to signal with accounting accruals have not been
investigated. Although firm-specific economic factors af-
fecting managers’ tendency to signal with financial policies
313
have been studied (Jensen et al., 1992; Kao and Wu, 1994;
Yoon and Starks, 1995), the determinants of the propensity
to signal with accounting accruals remain unexplored.
Considering the emerging importance of research on banks’
major accrual (i.e., LLP), it clearly is important to identify
underlying factors that explain banks’ signaling through
LLP. This study attempts to do so. Knowledge of such
factors will enable users to better understand and interpret
the information conveyed by reported accounting earnings.
Additionally, by understanding the conditions under which
managers use their discretion over LLP to communicate
their private information, regulators can distinguish between
managers’ use of accounting discretion for opportunistic
purposes and their use of accounting discretion to increase
the informativeness of reported earnings.
Most prior studies in this line of research estimate the
relationship between LLP and bank managers’ underlying
incentives using pooled time-series cross-sectional regres-
sions. While such an approach is computationally simple
and parsimonious, the assumption of a single, sample-wide
relation fails to incorporate any form of heterogeneity
among banks. To the extent that individual bank differences
are relevant, those differences could alter the outcome of the
tests if they are not specifically modeled because estimates
of the signaling parameter will be less precise and the
related test statistics downward biased. Prior research
reports that bank managers’ discretion over LLP is bank-
specific, suggesting that parameters of interest should be
measured relative to within-bank means rather than relative
to annual or pooled cross-sectional means as in most of
those prior studies. This study uses a bank-specific time-
series approach in an attempt to address the above concerns.
Additionally, using a bank-specific approach facilitates
gaining insights into factors contributing to differences in
the propensity to signal through LLP. This research exam-
ines four bank-specific factors, which reflect the degree of
information asymmetry across banks: bank size, earnings
variability, future investment opportunities, and degree of
income smoothing.
The empirical evidence indicates that the propensity to
signal differs across banks based upon the degree of infor-
mation asymmetry. It varies negatively with bank size and
positively with earnings variability, future investment op-
portunities, and degree of income smoothing. These findings
have at least two important implications. First, they indicate
that using a bank-specific time-series approach that allows
for differences in the propensity to signal rather than a cross-
sectional approach that constrains the signaling propensity to
be constant across banks leads to more precise parameter
estimates and less biased test statistics. Second, these results
have implications for interpreting the findings of prior
research and for the design of future research on income
smoothing and capital management through discretionary
LLP. By incorporating the bank-specific factors affecting
signaling propensity that are identified in this study in their
research designs, that research can better control for differ-
314 K. Kanagaretnam et al. / Journal of Business Research 58 (2005) 312–320
ential signaling incentives, thereby facilitating more power-
ful tests of income smoothing and capital management.
In the next section, we discuss potential determinants of
signaling through LLP and develop testable hypotheses. We
describe the data and sample selection in section 3, and the
empirical specifications and testing approach in section 4.
We discuss the results in section 5 and present the con-
clusions of the study in section 6.
2. Determinants of LLP signaling
Managers’ incentives to signal are motivated by their
concerns about stock undervaluation resulting from infor-
mation asymmetry. Prior research attributes interfirm differ-
ences in information asymmetry to the following factors:
firm size, earnings variability, investment opportunity, own-
ership concentration, strength of governance/monitoring
mechanisms, and degree of income smoothing. Addressing
the governance and ownership explanations are beyond the
scope of this research. Consequently, this study focuses on
the remaining four firm-specific characteristics: firm size,
earnings variability, investment opportunity, and degree of
income smoothing.
2.1. Bank size
The information environment hypothesis suggests that
larger banks are more closely monitored by regulatory
agencies and followed by more analysts. Such banks are
more likely to have strong linkages with analysts and
institutional investors. As a result, managers of larger banks
will have less private information to signal through LLP
and, consequently, are less likely to use signaling devices
including LLP to communicate their private information.
Similarly, the extant literature on determinants of firms’
disclosure policies documents a positive association be-
tween disclosure quality and firm size (Imhoff, 1992; Lang
and Lundholm, 1993). This suggests that enhanced disclo-
sure quality will mitigate the information asymmetry be-
tween inside managers and outside investors, thereby
resulting in a weaker incentive to signal through accounting
accruals. Hence, we hypothesize the following:
Hypothesis 1: The propensity to signal is negatively related
to bank size.
2.2. Earnings variability
Gebhardt et al. (2001) report that the implied risk
premium is consistently higher for commercial banks and
that earnings variability and predictability are important
factors in explaining cross-sectional differences in implied
risk premium. Financial practitioners also regard earnings
variability as an indicator of risk. Barth et al. (1995) argue
that bank shareholders will demand a higher risk premium
for the increased riskiness perceived from a more variable
earnings stream. This suggests that managers of banks with
higher earnings variability will have higher incentives to
signal their future earnings prospects.
Theoretical support for the relation between earnings
variability and the propensity to signal is also provided by
two related streams of research. First, market microstruc-
ture theory maintains that more noisy earnings tends to
exacerbate information asymmetries between the bank’s
management and outside investors, and between privately
informed investors and market makers. To compensate for
this informational disadvantage, the market maker’s in-
crease in the bid-ask spread will be greater for banks with
less predictable earnings (Affleck-Graves et al., 2002). The
resulting increase in the adverse selection component of the
bid-ask spread will increase the bank’s cost of capital. If the
manager of a bank with high historical variability in
earnings can reduce the adverse selection component of
the bid-ask spread, then the bank’s trading costs will be
lower and the market for its securities more liquid, making
the securities themselves more valuable (Callahan et al.,
1997). This suggests that managers of banks with relatively
high earnings variability are more likely to engage in
signaling through LLP to reduce the adverse selection
component of the bid-ask spread and, consequently, their
cost of capital.
From a different perspective, if an increase in a firm’s
earnings variability increases information asymmetry due to
the noise created by low predictability of earnings prospects,
then the management of such a firm will have a greater
incentive to signal. According to signaling rationales for
voluntary disclosure proposed by Ross (1977) and Verrec-
chia (1983), managers with information about their firm
being undervalued will disclose it credibly so that their stock
price will be revised upward, whereas managers with infor-
mation that implies values below market will withhold their
information. Accordingly, if earnings variability increases
information asymmetry and thus results in undervaluation of
the firm, then managers of banks with high earnings vari-
ability will have greater incentives to signal their information
about their banks’ future favorable prospects. The above
discussion suggests the following hypothesis:
Hypothesis 2: The propensity to signal is positively related
to earnings variability.
2.3. Investment opportunity set
Cross-sectional differences in propensity to signal may
also be related to investment opportunities. Generally, firms
with higher investment opportunities or growth potential
have more flexibility in their choice of future investments
(Titman and Wessels, 1988). The assets of growth firms are
generally more difficult to observe because they are primar-
ily represented by future (unrecognized) investments. If so,
there is likely to be more information asymmetry for firms
 K. Kanagaretnam et al. / Journal of Business Research 58 (2005) 312–320
with higher investment opportunities. Arguably, because the
degree of information asymmetry is more pronounced for
firms with more discretion in their choice of investment
decisions, firms that derive a relatively higher proportion of
their market value from growth options relative to assets in
place will have stronger incentives to signal.
Relying on the foregoing, Ballester et al. (1998), hy-
pothesize that growth firms have higher levels of abnormal
earnings than other firms because they have greater levels
of unrecorded economic assets. Conceptually, growth firms
should enjoy greater abnormal earnings than those expected
by the market because they have some economic assets that
are not fully reflected in financial statements. Furthermore,
the concurrent nature of uncertainty surrounding a larger
portion of their assets will motivate bank managers to
signal more to communicate to investors that the future
earnings prospects of their banks will exceed current market
expectations.
The implication of the above arguments is that banks
with positive changes in net investments will signal more
through LLP to mitigate the underpricing of securities
resulting from adverse selection by the market. This sug-
gests the following hypothesis:
Hypothesis 3: The propensity to signal is positively related
to the size of the investment opportunity set.
2.4. Degree of income smoothing
There are alternative views in the literature about why
managers engage in income smoothing. One is that if the
income smoothing arises because of a need to reduce
information asymmetry, then income smoothing will make
the reported earnings more reflective of future perfor-
mance (e.g., Warfield et al., 1995; Beatty and Harris,
1999). An alternative view is that, if the income smooth-
ing arises to circumvent contracts designed to mitigate
agency costs, then, the earnings management will make
the reported earnings less reflective of future performance.
Since our focus is on signaling for information enhance-
ment, we do not discuss the effect of opportunistic income
smoothing.
According to the information enhancement viewpoint,
income smoothing occurs when managers have superior
information about the value of their firm and want to
communicate it to outsiders. Consequently, income smooth-
ing is viewed as an additional signaling device for convey-
ing managers’ favorable private information about their
firms. Chaney and Lewis (1995) develop a model in which
managers of high quality firms smooth reported earnings to
convey their private information. They hypothesize that
managers have private information about their firm type
indicating that the expected value of the cash flow distri-
bution is larger for higher quality firms. Kao and Wu (1994)
demonstrate that smoothing enhances the quality of signal-
ing because it reduces noise.
315
In sum, the above discussion implies that income
smoothing enhances the quality of signaling; therefore, it
complements the signaling through LLP. Thus, we posit the
following:
Hypothesis 4: The propensity to signal is positively related
to the degree of income smoothing.
3. Empirical models
This section presents the model used for estimating the
propensity to signal through LLP and the model for testing
the determinants of signaling. Next, it describes operational
measures of the signaling determinants.
3.1. Model for estimating propensity to signal
The following model is used for estimating the propen-
sity to signal:
LLPit ¼ a0i þ a1i LCOit þ a2i LLAit1 þ a3i CHNPLit
þ di EBTPit þ ki CHEBTPitþ1 þ ci CAPit
þ /i CAPit  REG þ eit ð1Þ
where, for firm i in period t, LLPit = loan loss provision,
LCOit = net loan charge-offs, LLAit  1 = beginning loan
loss allowance, CHNPL it = change in nonperforming
loans, EBTP it = earnings before tax and provision,
CHEBTPit + 1 = 1-year ahead change in earnings before tax
and provision, CAPit = ratio of actual regulatory capital
before loan loss reserves to required regulatory capital,
REG = one in the new capital regime (after 1990) and zero
in the old regime (1990 or earlier), ki = signaling coefficient,
di = income-smoothing coefficient, ci, /i = capital manage-
ment coefficients. All variables other than CAP are deflated
by beginning market value of equity.
If managers use LLP to signal future prospects, then the
signaling parameter, ki, in Eq. (1) is expected to be positive.
For signaling, LLP will be high when 1-year-ahead change
in premanaged earnings (CHEBTPt + 1) is high. To examine
bank managers’ signaling behavior through LLP, we com-
pute a t statistic for the signaling parameter (ki) for each
sample bank. The t statistics are then aggregated across
sample banks to obtain a z statistic, as described in Dechow
et al. (1994). This z statistic, which is distributed asymptot-
ically as a standard normal variate, is used to assess the
statistical significance of our signaling hypothesis test.
We include earnings before tax and provision (EBTPit)
and primary capital ratio (CAPit) to control for the potential
effects on discretionary LLP of motivations related to
income smoothing and capital management. If discretionary
components of unexpected provisions are used by bank
managers to smooth earnings, then the income smoothing
316 K. Kanagaretnam et al. / Journal of Business Research 58 (2005) 312–320
parameter (di) is expected to be positive. The capital
management hypothesis (Moyer, 1990; Beatty et al., 1995;
Ahmed et al., 1999) posits that managers of banks with low
regulatory capital have incentives to increase LLP because
primary capital includes loan loss reserve. This suggests that
the coefficient of primary capital (ci) will be negative.
However, the 1990 change in bank capital adequacy regu-
lations substantially reduced the incentive to manage capital
via LLP. Therefore, if the capital management incentive has
declined in the new capital regime, the parameter (ci + /i)
should not differ from zero.
The model also includes net loan charge-offs, change in
nonperforming loans, and beginning loan loss allowance to
explicitly account for the nondiscretionary portion of LLP.
Net loan charge-offs (LCOit) is related to LLP by construc-
tion. Change in nonperforming loans (CHNPLit) will also
have a positive effect on LLP, whereas beginning loan loss
allowance (LLAit  1) will have a negative effect on LLP. A
large beginning allowance will require a smaller provision
in the current period, and vice versa. Our choice of these
variables for estimating nondiscretionary LLP is consistent
with prior studies (Wahlen, 1994; Beaver and Engel, 1996;
Kim and Kross, 1998).
3.2. Model for testing the determinants of signaling
The signaling parameter estimated for each sample bank
in Eq. (1) represents the bank’s propensity to signal. The
purpose of the second-stage regression analysis presented in
this subsection is to examine the relationships between the
strength of LLP signaling and bank-specific economic
factors. Accordingly, we estimate the following cross-sec-
tional regression (expected signs for the coefficient esti-
mates are in parentheses):
ðÞ ðþÞ ðþÞ
ki ¼ x0 þ x1 SIZEi þ x2 EVARi þ x3 INVi
ðþÞ
þ x 4 di þ li ð2Þ
where, for bank i, ki = signaling coefficient (from Eq. (1)),
SIZEi = average size over the sample period, EVARi = earn-
nings variability over the sample period, INVi = investment
opportunities over the sample period, di = degree of income
smoothing (from Eq. (1)).
Note that Eq. (2) includes ki as the dependent variable
and di as an independent variable. Because di is estimated
from the first-stage model, it is stochastic. This causes OLS
parameter estimates to be inefficient and statistical infer-
ences to be unreliable (Pindyck and Rubenfeld, 1991). The
appropriate technique for obtaining efficient coefficient
estimates is to use weighted least squares estimation with
‘‘weighting’’ factors that take into account the variance –
covariance structure of these stochastic variables. The
weights are w i = Var[ki ]  (Cov[ki ,di ])/Var[di ], where
Var[ki], Var[di]) and (Cov[ki, di]) are the variances and the
covariance of ki and di, generated from estimating Eq. (1).
Accordingly, all regression variables in Eq. (2), including ki
and di, are deflated by wi.
3.3. Measures of signaling determinants
Section 2 discussed the rationales for the hypothesized
relationships between the propensity to signal and its four
determinants—bank size, earnings variability, investment
opportunity set, and degree of income smoothing. Measures
of the degree of income smoothing (di) are obtained from
Eq. (1). In this subsection, we describe the measurement of
the remaining three determinants which are estimated using
annual data over the entire sample period (1981 –1996).
3.3.1. Bank size (SIZE)
Bank size is measured as the natural logarithm of total
loans outstanding at the end of each year. Unlike alternative
size proxies such as market value of equity and total assets,
total loans outstanding is well-suited for this study primarily
because the room for managerial discretion over LLP
mainly depends upon the magnitude of outstanding loans.
3.3.2. Earnings variability (EVAR)
Earnings variability is defined as the standard deviation of
earnings per share over the sample period. Variability in the
earnings series increases the bank’s probability of bankrupt-
cy as well as its perceived risk. This, in turn, increases its cost
of capital. We calculate earnings variability as follows:
vffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
uN
uP
u ðEPSit  EPSi Þ2
t t¼1
EVARi ¼
N
where, for bank i, EVARi = earnings variability over the
sample period, EPSit = earnings per share excluding extraor-
dinary items in year t, EPS i = mean earnings per share
excluding extraordinary items over the sample period,
N = number of observations over the sample period.
3.3.3. Investment opportunity set (INV)
Kallapur and Trombley (1999) provide a comprehensive
evaluation of the association between alternative investment
opportunity set proxies and realized growth. Based on an
analysis of annual samples comprising all Compustat firms
centered on 1978 through 1991 as base years, they document
that the book-to-market ratio is the measure most highly
(negatively) correlated with future growth. Following Kalla-
pur and Trombley (1999), we employ the ratio of the market
value to the book value of total assets as a proxy for the
relative importance of investment opportunities, where the
market value of total assets is defined as the ending market
value of common equity plus the book value of preferred
equity and liabilities. This measure has previously been used
by Smith and Watts (1992) and Mian (1996), among others,
to differentiate between assets in place and growth opportu-
nities. It relies on the notion that, if firms’ growth prospects
 K. Kanagaretnam et al. / Journal of Business Research 58 (2005) 312–320 317

are at least partially impounded in stock prices, then growth
firms will have higher market values relative to assets in
place. For example, banks with highly competent derivatives
experts will have an unrecorded economic asset. This will
cause higher abnormal earnings and will, in time, result in
relatively higher stock prices. Since the market-to-book ratio
indicates the discrepancy between market price and book
value, banks with higher ratios will have relatively higher
information asymmetries and, not surprisingly, higher un-
certainty in their future income streams. Therefore, the need
for communicating favorable future prospects by managers
of such banks will be relatively greater.
4. Sample selection and descriptive statistics
Our sample includes banks from the 1997 Bank Compu-
stat annual file that also have nonperforming loans informa-
tion for the period 1980 – 1997 available in the Keefe,
Bruyette, and Woods (KBW) database. The 1997 Bank
Compustat file contains 14,080 bank-year observations for
705 banks for the period 1978 – 1997. Eliminating banks
lacking the necessary financial data leaves 3068 bank-year
observations. From these, 1410 bank-year observations are
deleted due to first-differencing in total outstanding loans
and 1-year-ahead changes in earnings before tax and provi-
sion. To facilitate the firm-specific time-series regression
analysis, we also require that sample firms have at least 10
years of data available. This requirement leaves 1253 obser-
vations (102 banks). Merging the Compustat and KBW
databases results in a final sample of 1120 observations,
spanning 16 years (1981 –1996) and including 78 banks.
Table 1 provides descriptive statistics of key variables. As
shown in Panel A, the mean LLP is greater than the mean
loan charge-off indicating that there is, on average, discre-
tionary addition to the loan loss allowance by charging more

Table 1
Descriptive statistics
Panel A: Unscaled variables in the first-stage model
Totals (US$MM except for CAP)
Variable Mean S.D. Min 25% Median 75% Max
LLP 111.6 642.0  60 7.21 19.02 64.80 4410
LCO 97.74 297.7  16.08 5.70 15.36 58.94 4934
LLAt  1 245.1 591.9 0 22.08 50.93 167.0 5368
CHNPL 8.360 253.99  2391  8.14 1.100 13.95 3463
NI 360.58 751.0  259.2 47.83 102.2 314.6 7999
CAP 1.51 0.305 0.706 1.284 1.509 1.714 2.759
CHEBTPt + 1  4.433 423.9  7789 1.692 11.71 37.0 2229
MV 1669.9 3406.7 6.75 223.18 522.1 1490.9 47,711

Panel B: Ratios
Ratio Mean Median S.D.
NPL/MV 0.17 0.08 0.32
LLP/MV 0.08 0.04 0.16
LCO/MV 0.06 0.03 0.11
NPL/LLA 0.96 0.81 0.73
NPL/LLP 3.32 2.03 9.84
NPL/LCO 2.75 2.60 53.4
LLP/LCO 1.47 1.23 7.94
LLP/NI 1.57 0.29 23.0

Panel C: Variables in the second-stage model

Variable Mean S.D. Min 25% Median 75% Max
k 0.050 0.187  0.346  0.032 0.020 0.093 0.884
SIZE 8.441 1.199 5.714 7.524 8.187 9.536 11.75
EVAR 1.720 1.510 0.173 0.791 1.318 2.096 9.357
INV 1.026 0.039 0.757 1.016 1.026 1.037 1.126
d 0.117 0.362  0.803  0.011 0.100 0.245 1.293
Variables are defined as follows: LLPit = loan loss provision (Bank Compustat #135), LCOit = net loan charge-offs (Bank Compustat #190),
LLAit  1 = beginning loan loss allowance (Bank Compustat #70), NPLit = beginning nonperforming loans, CHNPLit = change in nonperforming loans,
CAP = ratio of actual regulatory capital before loan loss reserves to required regulatory capital, EBTPit = earnings before tax and provision (Bank Compustat
#161+#135), CHEBTPit + 1 = one-year ahead change in earnings before tax and provision (Bank Compustat #145+#135), MVit = market value of equity (Bank
Compustat #90  #205), k = signaling coefficient estimated from Eq. (1), SIZE = average size, EVAR = earnings variability, INV = investment opportunities,
d = degree of income smoothing estimated from Eq. (1).
Variables are estimated over the period 1981 – 1996.
Descriptive statistics in panel C are based on 78 observations.
318 K. Kanagaretnam et al. / Journal of Business Research 58 (2005) 312–320

than needed for current write-offs. The ratios of average LLP,
loan charge-offs and nonperforming loans to average begin-
ning market value of common equity reported in Panel B are
0.08, 0.06, and 0.17, respectively. These ratios show im-
provement relative to Wahlen’s (1994) sample largely be-
cause the overall quality of loans has improved with the
economy over this period (Edwards and Mishikin, 1995).
Panel C of Table 1 reports descriptive statistics of
variables used in the second-stage regression model that
examines the hypothesized determinants of the propensity to
signal. On average, earnings are relatively unstable as
indicated by the earnings variability measure (EVAR). This
is so because the sample period of our study ranges from the
eighties when most banks suffered from ‘‘disintermedia-
tion’’ and a resulting decline in earnings to the nineties
when their profits increased sharply due to growth of
noninterest income derived from off-balance-sheet activities
such as fee and trading income.
5. Results
5.1. Evidence on signaling through LLP
Consistent with the signaling hypothesis, the bank-specif-
ic OLS regression results reported in Table 2 indicate a
significant positive association between LLP and change in
earnings before tax and provision. The mean (median)
signaling coefficient (k) is 0.059 (0.025); and 52 of the 78
firms exhibit positive coefficients. The z statistic for testing
the null hypothesis that the signaling coefficient equals zero is
3.568, significant at the 1% level. This result for signaling is
largely consistent with Elliott et al. (1991), Griffin and
Wallach (1991), Wahlen (1994), and Kanagaretnam et al.
(2003).
The mean (median) coefficient on income smoothing (d)
is 0.134 (0.119); and 61 of the 78 firms exhibit positive
coefficients. This result is consistent with those of prior
studies by Scholes et al. (1990), Wahlen (1994), Collins et al.
(1995), and Kanagaretnam et al. (2003). The mean coeffi-
Table 3
Pearson correlations among second-stage regression variables (N = 78)
k SIZE EVAR INV
SIZE  .009 (.936) –
EVAR .384 (.001) .418 (.001) –
INV .074 (.518)  .292 (.009)  .279 (.013) –
d .281 (.012)  .140 (.221)  .280 (.013)  .047 (.678)
See Table 1 for variable definitions.
Values in parentheses denote p values.
cient on capital management (c) is positive; however, the z
statistic is not sufficiently large to reject the null hypothesis
on capital management. Furthermore, roughly half of the 78
firms have positive capital management coefficients. This
result is consistent with the results of Collins et al. (1995)
and inconsistent with Moyer (1990), Beatty et al. (1995), and
Ahmed et al. (1999). Plausible explanations for these incon-
sistencies in tests of the capital management hypothesis
include the following: different sample periods, different
models to separate out the discretionary and nondiscretion-
ary components of LLP, and use of cross-sectional pooled
regression models that are less powerful in isolating this
managerial motive. The mean coefficient on the interaction
term (/) is negative, consistent with the argument that for the
period after 1990 the parameter (c + /) should not differ from
zero. The coefficients of all the control variables exhibit
statistically significant and predicted associations with LLP.
Finally, the mean (median) R2 is 0.875 (0.938) suggesting
that the model has, on average, high explanatory power in
explaining banks’ LLP decisions.
5.2. Evidence on determinants of signaling
5.2.1. Correlation analysis
Table 3 reports Pearson correlation coefficients among the
variables included in the second-stage regression model that
examines the relationships between the propensity to signal
and firm characteristics. As hypothesized, all the determi-
nants of signaling exhibit the predicted signs. The simple
correlations of propensity to signal with earnings variability

Table 2
First-stage bank-specific OLS regressions: results are reported for 78 bank-specific regressions
LLPit ¼ a0i þ a1i LCOit þ a2i LLAit1 þ a3i CHNPLit þ di EBTPit þ ki CHEBTPitþ1 þ ci CAPit þ /i CAPit REG þ eit

a0 a1 a2 a3 d k c / Adjusted R2
(?) (+) () (+) (+) (+) () (+)
Mean 0.012 1.092  0.456 0.089 0.134 0.059 0.437  0.178 0.875
Median  0.001 1.055  0.400 0.048 0.119 0.025 0.164  0.050 0.938
Third Quartile 0.045 1.455  0.199 0.154 0.257 0.089 0.823 0.095 0.967
First Quartile  0.042 0.729  0.795  0.035 0.014  0.025  0.386  0.222 0.844
Maximum 0.670 2.872 2.497 1.143 1.293 0.884 6.501 1.956 0.995
Minimum  0.511  0.610  1.973  0.799  0.803  0.652  4.142  4.048 0.304
Number > 0 39 75 10 47 61 52 46 30 –
z statistics2 0.809 39.287  14.337 4.151 10.391 3.568 1.216  2.646 –
One-tailed significance level 0.1867 0.0001 0.0001 0.0377 0.0001 0.0001 0.1131 0.0041 –
See Table 1 for variable definitions.
REG = 1 after 1990 and 0 otherwise.
 K. Kanagaretnam et al. / Journal of Business Research 58 (2005) 312–320
Table 4
WLS regression results for determinants of signaling (N = 78)
ki ¼ x0 þ x1 SIZEi þ x2 EVAR þ x3 INVi þ x4 di þ li
Predicted sign Intercept (?) SIZE (  )
Coefficient  4.003  0.093
t value  3.082  4.098
p value 0.0029 0.0001
Adjusted R2=.6788
See Table 1 for variable definitions.
Significance levels denoted by p values are based on a one-tail test.
(EVAR) and degree of income smoothing (d) are statistically
significant while those with bank size (SIZE) and investment
opportunity set (INV) are not. The correlations between
earnings variability (EVAR) and bank size (SIZE), invest-
ment opportunity set (INV) and degree of income smoothing
(d) are also significant as is the correlation between bank size
(SIZE) and investment opportunity set (INV).
5.2.2. Regression analysis
Table 4 reports the weighted least squares regression
results for the relation between the propensity to signal (k)
and the selected bank-specific economic variables. The
coefficients of all four determinants exhibit the predicted
signs. Bank size (SIZE) has the predicted negative sign and
is statistically significant. Thus, the hypothesis that larger
banks have weaker incentives to signal than smaller banks is
statistically supported by the sample data.
Earnings variability (EVAR) has a positively significant
association with the strength of signaling at less than the 1%
level. This result supports the hypothesis that managers of
banks with high earnings variability have more incentive to
signal their banks’ future favorable prospects, presumably
because an increase in earnings variability increases the
information asymmetry stemming from unpredictability of
performance. Thus, the propensity to signal is greater when
outsiders do not know as much about the corporation and its
managers’ efforts as do insiders.
The results in Table 4 indicate that the coefficient on the
investment opportunity set (INV) is significantly positive at
the 1% level, which is consistent with the hypothesis that
banks with greater investment opportunities signal more
than do banks with fewer investment opportunities. Finally,
the estimated regression coefficient on the degree of income
smoothing (d) is significant and positive at less than the 1%
level. This result is consistent with the hypothesis that bank
managers’ smoothing through LLP is, in general, an effec-
tive means of enhancing their signaling.
6. Summary and conclusions
This study extends the literature on bank managers’ use
of their discretion in estimating LLP to communicate their
319
EVAR (+) INV (+) SMOOTHING (+)
0.144 4.572 0.416
9.557 3.785 8.887
0.0001 0.0001 0.0001
private information about their banks’ future prospects.
Unlike prior research which assumes that the propensity to
signal through LLP is uniform across banks, this study
posits that, because bank managers face different conditions
and have different incentives, their propensities to signal
their private information vary systematically with bank size,
earnings variability, future investment opportunities, and
degree of income smoothing.
Our empirical analysis indicates that the propensity to
signal is not cross-sectionally constant; it varies negatively
with bank size and positively with earnings variability, future
investment opportunities, and degree of income smoothing.
These results are consistent with the hypothesis that the
propensity to signal varies positively with the degree of
information asymmetry. They also are consistent with the
notion that managers have incentives to attenuate perceived
undervaluation of their banks by communicating their private
information about their banks’ favorable future prospects.
Our findings have implications for users of financial
statements and for policymakers. Knowledge of factors that
explain differences in the propensity to signal will enable
users to better understand and interpret the information
conveyed by reported accounting earnings. Furthermore,
by understanding the conditions under which managers
use their discretion over LLP to communicate their private
information, regulators can better distinguish between man-
agers’ use of accounting discretion for opportunistic pur-
poses and their use of accounting discretion to increase the
informativeness of reported earnings.
Our findings also have implications for interpreting the
findings of prior research and for future research in this area.
First, they demonstrate that using a bank-specific time-series
approach that recognizes firm-specific differences in the
propensity to signal rather than the commonly used cross-
sectional approach that ignores such differences results in
more precise parameter estimates and less biased test
statistics on signaling propensity. Second, our results have
implications for interpreting the findings of research on
income smoothing and capital management through discre-
tionary LLP. That research typically controls for the signal-
ing incentive by assuming that it is cross-sectionally
uniform. Given that there are systematic differences across
banks in the propensity to signal through LLP, as demon-
320 K. Kanagaretnam et al. / Journal of Business Research 58 (2005) 312–320
strated in this study, such controls will be less efficacious.
Incorporating the factors affecting the propensity to signal
that were documented in this study can help improve the
research designs of those studies.
Acknowledgements
We thank the two anonymous reviewers for their con-
structive suggestions. Gerald Lobo acknowledges the
financial support provided by the Office of the Vice President
of Research and Computing, the School of Management, and
the George E. Bennett Center at Syracuse University.
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