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, nonaudit 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.
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.
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This paper investigates the bank firms’ capital management via loan loss provision1.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
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.
1
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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
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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’
performance are more volatile while facing the same level of earnings and capital benchmark, and
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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
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.
2
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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
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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
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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
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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).
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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 offbalance activities into consideration 4 .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%.
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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
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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.
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”
5
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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 loss provision
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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).
Second, in contrast to agency theory, behavioral literature suggests that psychological heuristics
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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
provision is readily developed, as researchers can rely on generally accepted accounting
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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
study of relation between agency incentive and non-audit service purchase, Parkash and Venable
- 16 -
(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 variability6, 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 -
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 -
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 -
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   0  1T1C   2T 2C   3 LLR   4 EBTP   5 LOSS   6 BigFive
  7 LEVERAGE  
Where
T1C
T2C
LLR
EBTP
(1)
Ratio of Tier I capital before loan loss provision to risk-weighted total assets
Ratio of Tier II capital before loan loss provision to risk-weighted total assets
Ratio of Loan Loss Reserve loan loss provision to risk-weighted total assets
Earnings before taxes and loan loss provision/average total assets
- 20 -
LOSS
LEVERAG
Negative earnings before taxes and loan loss provision/average total assets
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, although
- 21 -
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   0  1T1C   2T 2C   3 LLR   4 EBTP   5 LOSS   6T1C * HNAF
  7T 2C * HNAF   8 LLR * HNAF   9 EBTP * HNAF  10 LOSS * HNAF
 11Big 5  12 LEVERAGE  
(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) + (1T)* 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 -
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 nondiscretionary 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 -
LOSS it   it   0 LASSETit  1NPLit   2 LLRit   3 LOANRit   4 LOANCit
(3)
 5 LOANDit   6 LOANAit   7 LOANI it  8 LOANFit   it
LOSS
NPL
=
=
LASSET
LLR
LOANR
LOANC
LOAND
LOANA
LOANI
LOANF
=
=
=
=
=
=
=
=
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;
loan loss reserve deflated by the total loans at the beginning of the year;
loans secured by real estate deflated by total loans;
commercial and industrial loans deflated by total loans;
loans to depository institutions deflated by total loans;
loans to finance agricultural production deflated by total loans;
loans to individuals deflated by total loans;
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 -

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 nonperforming 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
8
Federal Reserve Bank website of Chicago
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 -
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 nonaudit 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 -
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 -
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 -
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 nonaudit 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 -
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, twotailed 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 -
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 -
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 nonaudit 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 1011.
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 nonaudit 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 -
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 standalone 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 -
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 industryspecific 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 -
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 NonAudit 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; agreedupon 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 -
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
Earnings Quality
Prior Papers
Positive Association
Dee et al.(2002)
Ferguson et al.(2003)
Frankel et al.(2002)
Number
3
1
--only for income-decreasing
accruals
Ashbaugh et al.(2003)
--only for smallest firm groups
Chung and Kalllapur (2003)
--only for non-big five firms
Gore et al.(2001)
--only for firms with poor corporate
governance
Larcker and Richardson (2004)
1
1
1
Negative Association
No Association
Antle et al.(2002)
Firth (2002)
SharmaandSidhu (2001)
Pringle Buchman (1996)
Bajaj et al. (2003)
Chung and Kalllapur (2003)
Craswell (1999)
Craswell et al.(2002)
DeFond et al. (2002)
Kinney et al.(2003)
Krishnan (2003)
Li et al.(2003)
Raghunandan et al.(2003)
Ruddock et al.(2003)
Larcker and Richardson.(2004)
- 39 -
3
12
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.
Mean
Standard
Deviation
First
Quartile
Median
Third
Quartile
Minimum
Maximum
Panel A: Mandatory Disclosure of Fee Data
Audit
Audit/Total
665.20
70.73%
2916.91
18.32%
75.50
59.94%
135.20
73.69%
345.40
84.37%
0.07
6.36%
55000.00
100.00%
NonAudit
NonAudit/Total
487.96
29.27%
2521.77
18.32%
22.00
15.63%
49.47
26.31%
131.18
40.06%
0.00
0.00%
58700.00
93.64%
IS
IS/Total
1.00
0.07%
37.20
1.41%
0.00
0.00%
0.00
0.00%
0.00
0.00%
0.00
0.00%
1491.00
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
Audit-Related/Total
215.89
9.50%
878.19
11.15%
10.64
0.00%
23.50
6.30%
62.73
14.20%
0.00
0.00%
9900.00
72.37%
Tax
Tax/Total
271.25
10.10%
1393.00
10.91%
9.00
0.00%
20.78
7.56%
66.75
14.31%
0.00
0.00%
15300.00
74.77%
All Other
All Other/Total
240.74
9.59%
1767.31
16.88%
6.22
0.00%
23.79
0.05%
73.40
12.25%
0.00
0.00%
35300.00
93.64%
Variable
- 40 -
Table 2: Descriptive statistics of fees disclosed by Big-Five and Non-Big Five auditors in banking holdings companies (2001-2005)
The table reports descriptive statistics of auditor fees disclosed by Big-Five and Non-Big-Five auditors respectively from year 2001 to
year 2005.In particular, the Big-Five Auditors are Arthur Andersen (AA), Deloitee & Touché(D&T), Ernst & Young(E&Y),
KPMG(KPMG), and PricewaterhouseCoopers(PWC). The auditors included in the category of " Non-Big Five Auditors " with
observations exceed 50 are as follows: Beard Miller Company LLP,Crowe Chizek and Company LLC,Dixon Hughes PLLC,Moss Adams
LLP and Yount, Hyde & Barbour P.C. All fees are in thousands of dollars.
Panel A: Big-Four Auditors, Fees are divided by Total Auditor Fees
Variable
Total Fees
Audit/Total
NonAudit/Total
IS/Total
Audit-Related/Total
Tax/Total
All Other/Total
Mean
Standard
Deviation
First
Quartile
Median
Third
Quartile
Minimum
Maximum
2083.18
69.96%
30.04%
0.08%
9.04%
11.48%
9.44%
6884.56
20.22%
20.22%
1.62%
11.03%
13.23%
17.99%
206.04
58.34%
14.14%
0.00%
0.00%
0.00%
0.00%
466.23
73.68%
26.32%
0.00%
5.40%
7.46%
0.00%
1023.65
85.86%
41.66%
0.00%
13.44%
17.77%
9.97%
41.00
6.36%
0.00%
0.00%
0.00%
0.00%
0.00%
74200.00
100.00%
93.64%
43.60%
72.37%
74.77%
93.64%
Minimum
Maximum
0.09
15.57%
0.00%
0.00%
0.00%
0.00%
0.00%
2049.08
100.00%
84.43%
26.77%
67.86%
43.44%
81.58%
Panel B: Non- Big-Four Auditors, Fees are divided by Total Auditor Fees
Variable
Total Fees
Audit/Total
NonAudit/Total
IS/Total
Audit-Related/Total
Tax/Total
All Other/Total
Mean
Standard
Deviation
First
Quartile
Median
Third
Quartile
167.18
71.55%
28.45%
0.07%
9.99%
8.64%
9.75%
170.90
16.05%
16.05%
1.16%
11.26%
7.45%
15.63%
81.57
61.91%
16.31%
0.00%
0.00%
3.27%
0.00%
119.17
73.79%
26.21%
0.00%
7.20%
7.61%
0.85%
191.15
83.69%
38.09%
0.00%
15.37%
12.24%
13.40%
- 41 -
Table 3: Time-series analysis of audit and Non-audit fees and ratios of bank holding firms (2001-2005)
This table presents the median of audit fee, non-audit fee, total fee, audit ratio and non-audit ratio for 1609 bank holding firm-year
observations from year 2001 to year 2005. Panel A.B and Panel C report the medians of full sample, Big-Five sample and Non-Big-Five
sample respectively. All fees are in thousands of dollars.
Year
Panel A: Full Sample
2001
2002
2003
2004
2005
Audit fee
NonAudit Fee
Total Fees
Audit ratio
NonAudit Ratio
98.90
100.00
116.35
208.12
215.00
58.00
52.02
47.21
45.29
46.90
171.00
159.45
176.09
269.65
290.50
62.72%
67.43%
71.31%
79.85%
81.65%
37.28%
32.57%
28.69%
20.15%
18.35%
Panel B: Big-Five Sample
2001
2002
2003
2004
2005
188.00
205.00
256.13
519.17
529.30
131.41
110.00
98.97
102.79
90.25
308.03
320.06
332.98
608.78
647.00
58.43%
65.26%
71.24%
82.69%
83.96%
41.57%
34.74%
28.76%
17.31%
16.04%
Panel C: Non-Big-Five Sample
2001
2002
2003
2004
2005
62.67
71.80
72.55
100.41
118.58
35.46
32.01
31.00
31.95
33.30
102.54
107.29
107.50
135.64
158.59
66.79%
68.74%
70.52%
77.20%
79.49%
33.21%
31.26%
29.48%
22.80%
20.51%
- 42 -
Table 4: Descriptive statistics of major regression variables (2001-2005)
This table reports descriptive statistics of major 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. Total assets (TA) of bank firms at year end, is dollar amount in millions.
Variable
Mean
DLLP
NAF
TIC
T2C
LLR
EBTP
LEVERAGE
LN(TA)
STD(NAF)
ROA
0.000
0.293
12.429
1.260
0.011
0.069
1.036
14.200
0.129
0.011
STD
0.003
0.183
3.350
1.020
0.035
0.767
2.388
1.575
0.070
0.004
Min
25%
-0.018
0.000
5.386
-4.314
-0.024
-14.041
0.017
12.040
0.000
-0.021
-0.002
0.156
10.488
0.753
0.007
0.000
0.897
13.118
0.075
0.009
Median
0.000
0.263
11.826
0.969
0.009
0.091
0.908
13.728
0.118
0.011
75%
Max
0.001
0.401
13.484
1.296
0.011
0.190
0.919
14.893
0.178
0.013
0.049
0.936
46.401
9.849
0.895
19.745
49.928
21.125
0.363
0.047
Variable Definitions
DLLP
NAF
T1C
T2C
LLR
EBTP
LEVERAG
LN(TA)
STD(NAF)
ROA
Discretionary loan loss provisions from Beatty et al (2002) model
Non-audit service fee to total fee ratio, non-audit service fee is the sum of auditrelated fee, tax fees, other advisory fees, IS and all other fees
Ratio of Tier I capital before loan loss provision to risk-weighted total assets
Ratio of Tier II capital before loan loss provision to risk-weighted total assets
Ratio of Loan Loss Reserve before loan loss provision to risk-weighted total assets
Earnings before taxes and loan loss provision/average total assets
Ratio of total liability to average total assets
Natural log of total assets at year end
Standard deviation of non-audit service fee ratio for each bank firm
Net income divided by average total asset
- 43 -
Table 5: Evidence of new capital and earnings management mechanisms under Basel Accord (20012005) Dependent variable= DLLP, N=1, 609
This table presents evidences of new earnings and capital management behaviors of bank firms via loan
loss provision under Basel Accord. The dependent variable is discretionary loan loss provision. Results
show, instead of the positive effect in the old capital requirement regime, loan loss provision has negative
impact on Tier I capital. This suggests that firms would like to lower loan loss provision to increase Tier I
capital. Firms are more likely to increase loan loss provision when Tier II capital, and this incentive is
much strong when loan loss reserve is at low level. Consistent with literature evidence, the coefficient
between loan loss provision and earnings is positive since loan loss provision works as a pure expense to
decrease income before tax.
Basic Model:
DLLP   0  1T1C   2T 2C   3 LLR   4 EBTP   5 LOSS   6 BigFive
  7 LEVERAGE  
Independent Variable
Coefficient Estimates
Two Tailed p-value
(Constant)
-0.0006
0.02
T1C
0.0003
0.00
T2C
-0.0002
0.00
LLR
-0.0102
0.00
EBTP
0.0003
0.01
LOSS
-0.0018
0.47
Big Five
-0.0004
0.02
LEVERAGE
0.0000
0.55
R-square
2.91%
Adjusted R-square
2.48%
Variable Definitions
DLLP
T1C
T2C
LLR
EBTP
LOSS
Big5
LEVERAG
Discretionary loan loss provisions from Beatty et al (2002) model
Ratio of Tier I capital before loan loss provision to risk-weighted total assets
Ratio of Tier II capital before loan loss provision to risk-weighted total assets
Ratio of Loan Loss Reserve before loan loss provision to risk-weighted total assets
Earnings before taxes and loan loss provision/average total assets
Negative earnings before taxes and loan loss provision/average total assets
Dummy variable, equal to 1 if the auditor firm is one of the big five auditors
Ratio of total liability to average total assets
- 44 -
Table 6: Interaction between Non-audit service provision and Banks’ manipulation behaviors
under Basel Accord (2001-2005) Dependent variable= DLLP, N=1, 609
This table presents the variations of bank firms’ manipulation behaviors via loan loss provision, within
the context of high level of non-audit service purchase. Results show that large amount of non-audit
service purchase encourage bank firm managements to involve in manipulation actions. That is, providing
rents to auditors strengthen the economic bond between bank firms and auditors, as a result, reinforce the
association between capitals and loan loss provisions.
Model:
DLLP   0  1T1C   2T 2C   3 LLR   4 EBTP   5 LOSS   6T1C * HNAF
  7T 2C * HNAF   8 LLR * HNAF   9 EBTP * HNAF  10 LOSS * HNAF
 11Big 5  12 LEVERAGE  
Independent Variable
Coefficient Estimates
Two Tailed p-value
(Constant)
-0.0005
0.10
T1C
0.0002
0.07
T2C
-0.0001
0.14
LLR
-0.0142
0.00
EBTP
0.0002
0.41
LOSS
-0.0028
0.41
T1C *HNAF
0.0002
0.00
T2C *HNAF
-0.0003
0.04
LLR* HNAF
0.0050
0.38
EBTP*HNAF
0.0002
0.48
LOSS*HNAF
0.0023
0.64
Big Five
-0.0004
0.04
LEVERAGE
0.0000
0.57
R-square
3.88%
Adjusted R-square
3.16%
Variable Definitions
T1C
T2C
LLR
EBTP
LOSS
HNAF
Big5
LEVERAG
Ratio of Tier I capital before loan loss provision to risk-weighted total assets
Ratio of Tier II capital before loan loss provision to risk-weighted total assets
Ratio of Loan Loss Reserve before loan loss provision to risk-weighted total assets
Earnings before taxes and loan loss provision/average total assets
Negative earnings before taxes and loan loss provision/average total assets
Dummy variable which equals one if the Non-audit fee to total fee ratio is above
the median level.
Dummy variable, equal to 1 if the auditor firm is one of the big five auditors
Ratio of total liability to average total assets
- 45 -
Table 7: Impact of Variability of non-audit service purchase on banks’ manipulation actions under
Basel Accord (2001-2005) Dependent variable= DLLP, N=1, 609
The table presents impacts of non-audit service purchase variability on the association between banks
managers’ manipulation incentives and loan loss provision (LLP). Two different measures (VAR) are
used to capture the non-audit service variability property. 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 lower than the sample
median level; in model (2), as an alternative measure, it is defines by the 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. Tier 1* VAR, Tier 2* VAR and EBTP*VAR are significant at
5%level, however, their signs are opposite to Tier 1, Tier 2 and EBTP. Regular and consistent non-audit
service purchases suppress the manipulations of bank firms in the expected direction. This could be
explained by the fact that continuous providing rents to auditors would not only increase detection
probability and pose higher litigation risk to auditors, perception of impaired honesty and low quality of
financial reporting also would trigger negative market reaction to bank firms. The two-tailed p-values are
stated in italic.
Model:
DLLP   0  1T1C   2T 2C   3 LLR   4 EBTP   5 LOSS   6T1C * RECUR
  7T 2C * RECUR   8 LLR * RECUR   9 EBTP * RECURR
 10 LOSS * RECU  11 Big 5  12 LEVERAGE  
Independent Variables
(Constant)
Model(1)
Model(2)
0.0001
0.0004
0.74
0.21
T1C
0.0003
0.0003
0.01
0.01
T2C
-0.0005
-0.0009
0.00
0.00
LLR
-0.0090
-0.0072
0.00
0.04
EBTP
0.0006
0.0008
0.00
0.00
LOSS
-0.0009
0.0106
0.78
0.78
-0.0002
-0.0001
0.01
0.00
0.0005
0.0001
0.00
0.00
-0.0063
-0.0011
0.25
0.17
T1C *VAR
T2C *VAR
LLR*VAR
- 46 -
EBTP*VAR
LOSS*VAR
Big Five
LEVERAGE
R-square
Adjusted R-square
-0.0006
-0.0001
0.01
0.02
-0.0017
-0.0051
0.72
0.74
-0.0004
-0.0004
0.01
0.02
0.0000
0.0000
0.50
0.45
4.48%
3.76%
5.11%
4.40%
Variable Definitions
T1C
T2C
LLR
EBTP
LOSS
RECUR (1)
RECUR (2)
Big5
LEVERAG
Ratio of Tier I capital before loan loss provision to risk-weighted total assets
Ratio of Tier II capital before loan loss provision to risk-weighted total assets
Ratio of Loan Loss Reserve before loan loss provision to risk-weighted total assets
Earnings before taxes and loan loss provision/average total assets
Negative earnings before taxes and loan loss provision/average total assets
Dummy variable, equal to 1 if the standard deviation of a firm’s non-audit service
fee is lower than the sample median level
An alternative measure of non-audit service purchase variability, proxied by the
standard deviation rank, equal to 1 if the standard deviation of the non-audit service
fee ratio is the highest rank
Dummy variable, equal to 1 if the auditor firm is one of the big five auditors
Ratio of total liability to average total assets
- 47 -
Table 8: Size effect on Banks’ Manipulation behavior under Basel Accord in 1991 (2001-2005)
Dependent variable= DLLP, N=1, 609
This table presents evidences of impact of banks firms’ size (total assets) on the relation between
regulatory capital and discretionary loan loss provision under Basel Accord 1991. Size effect is captured
by a SIZE dummy variable, which equals to 1 if total asset of a bank firm is below the median level of
this sample and 0 otherwise. The result shows size effect on Tier I and Tier II capital are significant. That
is, compare to large size bank firms, small firms are more likely to do capital management. This is could
be explained that large-size firms’ manipulation incentives are constrained by huge reputation cost and
litigation risk (Kellogg, 1984; Stice, 1991; Bonner et al, 1998).Furthermore, small firms have more
manipulation demand result from their volatile performance, and inefficiency internal control system
encourage them to do so.
Model:
DLLP   0  1T1C   2T 2C   3 LLR   4 EBTP   5 LOSS   6T1C * SIZE
  7T 2C * SIZE   8 LLR * SIZE   9 EBTP * SIZE  10 LOSS * SIZE
 11Big 5  12 LEVERAGE   13
Independent Variable
Coefficient Estimates
Two Tailed p-value
(Constant)
0.0002
0.38
T1C
0.0000
0.86
T2C
0.0000
0.70
LLR
-0.0085
0.01
EBTP
0.0005
0.00
LOSS
-0.0023
0.34
T1C *SIZE
0.0004
0.00
T2C *SIZE
-0.0013
0.00
LLR* SIZE
-0.0053
0.29
EBTP*SIZE
-0.0003
0.15
Big Five
-0.0005
0.00
LEVERAGE
0.0000
0.93
R-square
7.55%
Adjusted R-square
6.91%
13
LOSS*SIZE variable is deleted from the regression analysis by the statistic software since the variables are
constants or have missing correlations
- 48 -
Table 9: Impact of Interaction between HNAF and RCUR on bank management incentives
through LLP under Basel Accord (2001-2005) Dependent variable= DLLP, N=1, 609
The table presents impact of interaction between high non-audit service purchase level and its variability
on bank firms’ manipulation incentives through loan loss provision under Basel Accord. HNAF is defined
in table 6. VAR is a dummy variable, equal to 1 if the standard deviation of a firm’s non-audit service fee
is below sample median. The coefficient of EBTP*HNAF*VAR is significantly negative. 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 in large amount consistently and regularly
are less likely to manipulate earnings than those firms who purchased irregularly. However,
LLR%*HNAF*VAR is significantly negative, 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.
Independent Variable
Coefficient Estimates
Two Tailed p-value
(Constant)
-0.0004
0.16
T1C
0.0002
0.09
T2C
-0.0001
0.18
LLR
-0.0143
0.00
EBTP
0.0002
0.40
LOSS
-0.0028
0.41
T1C *HNAF
0.0003
0.00
T2C *HNAF
-0.0002
0.08
LLR*HNAF
0.0070
0.22
EBTP*HNAF
0.0004
0.15
LOSS*HNAF
0.0017
0.72
T1C *HNAF*VAR
0.0001
0.28
T2C *HNAF*VAR
-0.0001
0.81
LLR*HNAF*VAR
-0.0617
0.00
EBTP*HNAF*VAR
-0.0009
0.01
Big Five
-0.0004
0.02
LEVERAGE
0.0000
0.66
R-square
5.37%
Adjusted R-square
4.41%
* LOSS*HNAF*VAR variable is deleted from the regression analysis by the statistic software since the variables
are constants or have missing correlations
- 49 -
Table 10: Impact of the Interaction between HNAF and SIZE on bank management mechanisms
under Basel Accord (2001-2005) Dependent variable= DLLP, N=1, 609
The table presents evidences of how the interaction between high level of non-audit service purchase and
total assets of bank firms influence manipulation incentives through loan loss provision after 1991. HNAF
and SIZE are defined in previous tables. Although T1C*HNAF*SIZE is not significant, it has the sign
consistent with the results in table 8. T2C*HNAF*SIZE is negative and significant at 5% level, indicating
that, compare to large size firms, small firms are more likely to choose to purchase high level of non-audit
service and based on that they manipulate loan loss provision upward to reach the capital requirement
target when Tier II capital is low.
Independent Variable
Coefficient Estimates
Two Tailed p-value
(Constant)
-0.0004
0.17
T1C
0.0002
0.07
T2C
-0.0001
0.14
LLR
-0.0143
0.00
EBTP
0.0002
0.38
LOSS
-0.0028
0.42
T1C *HNAF
0.0003
0.00
T2C *HNAF
-0.0002
0.03
LLR*HNAF
0.0072
0.22
EBTP*HNAF
0.0003
0.35
LOSS*HNAF
0.0018
0.71
T1C *HNAF*SIZE
0.0001
0.59
T2C *HNAF*SIZE
-0.0008
0.00
LLR* HNAF*SIZE
-0.0113
0.12
EBTP*HNAF*SIZE
-0.0003
0.27
Big Five
-0.0005
0.00
LEVERAGE
0.0000
0.82
R-square
5.11%
Adjusted R-square
4.16%
* LOSS*HNAF*SIZE variable is deleted from the regression analysis by the statistic software since the variables
are constants or have missing correlations
- 50 -
Appendix A. How to calculate Capital Adequacy Ratios
Total Capital Ratio 
Tier 1 Capital  Tier 2 Capital
Risk - weighted Asset - Exceeding LLR(if LLR  1.25% GRWA)
LLR: Loan Loss Reserve; GRWA: Gross Risk-Weighted Assets
Step1: Compute Tier I Capital
(a) Permanent shareholders’ equity:
Fully-paid ordinary shares/common stock (CS)
Perpetual non-cumulative preference shares (PS)
(b) Disclosed reserves:
Retained earnings (RE)
Mandatory convertible debt (CD)
Legal reserves (LR)
Other surplus (OS)
Deduction from Tier I capital: Goodwill
Step2: Compute Tier II Capital
(a) Undisclosed reserves(UR)
(b) Asset revaluation reserves (AR)
(c) Loan-loss reserves (LLR)
(d) Hybrid capital instruments (CI)
(e) Subordinated term debt (TD)
Restrictions of Tier II capital:
(i) The total of Tier II capital is limited to a maximum of 100% of the total of Tier I capital;
(ii) Subordinated term debt is limited to a maximum of 50% of Tier I capital;
(iii) Loan loss reserve included in Tier II capital is limited to a maximum of 1.25 percentages
points of risk-weighted assets;
(iv) Asset revaluation reserves which take the form of latent gains on unrealized securities is
subject to a discount of 55%.
Step3: Compute Total Capital
Total Capital= Tier I capital+ Tier II capital- Deductions
Deductions from Total capital:
(a) Investments in subsidiaries engaged in banking and financial activities which are not consolidated
in national systems, to prevent the multiple uses of the same capital resources in different parts of
the group.
- 51 -
(b) Investments in the capital of other banks and financial institutions, to avoid the cross-holdings of
bank capital designed artificially to inflate bank capital positions.
Step4: Compute Risk –Weighted Assets (RWA)
RWA is calculated by multiply relevant risk-weights to the value of both on-balance sheet items and offbalance sheet items.
On-Balance Sheet Items
Risk Categories
The framework of weights has been designed in a very simple way and only five weights are used: 0, 10,
20, 50 and 100% .For example:
Balance Sheet Risk Assets
Cash, Claims on central governments and central banks or claims ,
Federal balances, Treasury securities
General obligation municipal bonds, claims on multilateral development
banks, or cash items in process of collection
Loans fully secured by mortgage on residential property , or Revenue
municipal bonds
All other loans and investments, premises and equipment
Risk Weight
0%
20%
50%
100%
Off-Balance Sheet Items
In the Basel Accord, all off-balance-sheet activity is taken into account in the capital adequacy framework.
All categories of off-balance-sheet engagements are converted to credit risk equivalents by multiplying a
credit conversion factor, the resulting amounts then being weighted according to the nature of the
equivalent on-balance sheet counterparty. Credit conversion ratios are derived from the estimated size and
likely occurrence of the credit exposure, as well as the relative degree of credit risk as identified in the
Committee’s paper "The management of banks’ off-balance sheet exposures: a supervisory perspective"
issued in March 1986.
Off-Balance Sheet Items
Other loan commitments with an original maturity of up to one year ,or
which can be unconditionally cancelled at anytime
Short-term self-liquidating trade-related contingencies, eg, commercial
letter of credit
Transaction-related contingent items, note issuance facilities and
revolving underwriting facilities
Direct credit substitute, sale and repurchase agreements, asset sales with
recourse, Forward asset purchases, forward deposits and partly-paid
shares and securities
Credit
Conversion Ratio
0%
20%
50%
100%
Total Risk –Weighted Assets (RWA) =Adjusted On-Balance Sheet Items + Adjusted Off-Balance Sheet
Items
- 52 -
Appendix B. The net effect of Basel Accord Changes on Tier I and Tier II capital
I. Primary capital and Tier I capital
Primary Capital before 1988 Basel Accord
Primary capital consists of:
a) Fully-paid ordinary shares/common stock( CS)
b) Perpetual non-cumulative preference shares(PS)
c) Retained earnings(RE)
d) Loan Loss Reserve( LLR)
e) Mandatory convertible debt(CD)
f) Legal reserves(LR)
g) Other surplus(OS)
CS  PS  RE  LLR  CD  LR  OS
Gross Total Assets
LLP is related to LLR and RE. LLRT  LLPT 1  LLPT  LWOT ,that is , one unit increase of LLP increase
LLR by one unit .However, in the income statement LLP decrease the RE by (1-t) unit, t is the tax rate.
t * LLP
Therefore, the net effect of LLP on primary capital is the tax shield of LLP,
, in one
Gross Total Assets
word, LLP increase primary capital before the Basel Accord.
Primary Capital Ratio 
Tier I Capital after 1988 Basel Accord
CS  PS  RE  CD  LR  OS
Risk - weighted Asset - Exceeding LLR(if LLR  1.25% GRWA)
LLR is removed from the numerator of Tier I capital, therefore the net effect of LLP is
 (1  t ) * LLP
Risk - weighted Asset - Exceeding LLR(if LLR  1.25% GRWA)
Tier I Capital Ratio 
1) When LLR<1.25%GRWA, net effect of LLP is
 (1  t ) * LLP
, LLP has negative effect
Risk - weighted Asset
on Tier I capital ratio
2) When the LLR > 1.25% GRWA, the net effect of LLP is:
 (1  t ) LLP
Risk  Weighted Assets  ( LLP  1.25%GRWA)
Take the differentiate of the above formula respect to LLP, to make it looks simple, take
b= -1and all the other variables in the denominator as c, then
- 53 -
d
 (1  t ) LLPT
 (1  t ) LLPT
 (1  t )


bLLPT  c
bLLPT  c (bLLPT  c) 2
-(1-t)*LLP is the numerator , and(b*LLP+c) is the denominator, the condition need to
make LLP has negative effect is :
d
 (1  t ) LLPT
 (1  t ) LLPT
 (1  t )
 (1  t )
numerator




0
2
bLLPT  c
bLLPT  c (bLLPT  c)
deno min ator deno min ator 2
Assume the tax rate t=34%, we only need the denominator >1.5 times numerator so that LLP has
negative effect on Tier I capital even when LLR is larger than 1.25% of risk-weighted assets. And
this criterion can be fully satisfied in most banks.
Therefore LLP decrease Tier I capital ratio after Basel Accord in stead of increasing before 1988.
II. Secondary Capital and Tier II capital
Secondary capital after 1988 Basel Accord
Secondary capital before Basel Accord consists of:
(a) Undisclosed reserves(UR)
(b) Asset revaluation reserves (AR)
(c) Hybrid capital instruments (CI)
(d) Subordinated term debt (TD)
UR  AR  CI  TD
Secondary Capital Ratio 
Gross Total Assets
Tier II Capital after 1988 Basel Accord
The loan loss reserve (LLR) is shifted from Primary capital before 1988 to Tier II capital under Basel
Adequacy Accord, however, LLR qualifies to be included in Tier II capital is limited to 1.25% of Gross
Risk-Weighted Assets (GRWA)
Tier II Capital Ratio 
UR  AR  CI  TD  LLR(up to 1.25% GRWA)
Risk - weighted Asset - Exceeding LLR(if LLR  1.25% GRWA)
The net effect of LLP on Tier II capital is:
LLP
Risk - weighted Asset - Exceeding LLR(if LLR  1.25% GRWA)
That is, LLP has positive net effect on Tier II capital under the Basel Adequacy Accord.
- 54 -