Do Commercial Banks Use Loan Loss Provisions to Smooth Their Income? Empirical Evidence from Sri Lankan Commercial Banks

Abstract

Banking industry is one of the most profitable industries in Sri Lanka and lending operations constitute as the core banking business which is a highly risk area. As a tool to mitigate the credit risk that occurs in the banking business it involves in providing for loan losses which ultimately affect the profitability of the bank. This study therefore attempts to ascertain whether Sri Lankan Commercial banks use loan loss provisions to smooth their income. The time period considered for the study is 2003 to 2012 with a balanced set of panel data. Eight bank specific variables were used which are; capital adequacy ratio, change in total loans, change in non-performing loans, total loans, non-performing loans, earnings before tax and provisions, loans to deposit ratio and log value of total assets. First the whole sample was examined and later analysis was done to three major categories namely; public sector banks, systematically important private banks and small private banks. The findings reveal that private domestic licensed commercial banks use loan loss provisions to smooth the income while the public sector banks are not. Loan loss provisions of banks to a large extent is depend on four bank specific variables. It was further revealed that banks with high level of loan growth are associated with a reduced level of problem loans. Finally the study suggests important policy implications for bankers and regulators that might help to address income smoothing activities of financial sector in Sri Lanka.