Bank earnings and regulatory capital management using available for sale securities

We seek to determine the extent to which and how banks use available for sale (AFS) securities to manage earnings and regulatory capital. We find robust evidence that banks realize gains and losses on AFS securities to smooth earnings and regulatory capital. Prior research on investment securities implies these inferences. In addition, we find that banks with more unrealized gains and losses on AFS securities smooth earnings and regulatory capital more. We also find that banks with negative earnings engage in big bath earnings management (avoid reporting losses and smooth earnings), if their unrealized gains are insufficient (sufficient) to offset the negative earnings. In contrast to prior research, we find no evidence that banks smooth earnings to reduce information asymmetry; rather, we find the smoothing diminishes earnings quality. Our inferences all apply to publicly listed and non-listed banks, which indicates that the earnings management incentives do not derive solely from public capital markets. Together, our findings indicate that bank managers view earnings, not comprehensive income, as an earnings management target and that the accounting for AFS securities gains and losses enables banks to manage earnings and smooth regulatory capital.