Do Banks Really Sell Securities to Smooth Earnings?

Abstract

Accounting research has long claimed that banks time sales of available-for-sale securities to smooth earnings. We find that what the prior literature calls smoothing is more accurately characterized as boosting of low earnings. That is, the “smoothing” behavior is asymmetric, occurring at the low end of the earnings distribution, where banks sell at gains to boost low earnings. Furthermore, the intent behind some of this gain-selling at the low end of the earnings distribution appears to be to manage reported earnings from negative to positive, rather than to create a smooth earnings path. We also find that these gain-selling tendencies are of low frequency. At the high end of the earnings distribution, we find little statistically or economically significant earnings smoothing via realization of securities losses or realization of smaller-than-normal securities gains. Previously unavailable data that separates the net realized gain/loss into its gross components reveals that banks generally are reluctant to sell securities at losses, and when they do realize losses they typically offset the losses with realized gains. Overall, results suggest that when accounting standards insulate earnings from unrealized changes in security fair values, the primary form of earnings management that occurs is occasional gain-selling to boost low earnings or beat the zero-earnings benchmark.