Bank Earnings and Regulatory Capital Management using Available for Sale Securities

Based on a large sample of publicly listed and non-listed US commercial banks from 1996 to 2011, we find robust evidence consistent with banks using realized available for sale (AFS) securities gains and losses to smooth earnings and increase low regulatory capital. We also find (i) banks with positive earnings smooth earnings, and banks with negative earnings generally take big baths; (ii) regulatory capital constrains big baths, (iii) banks with more negative earnings and more unrealized beginning-of-quarter losses (gains) take big baths (smooth earnings); and (iv) banks with low regulatory capital and more unrealized gains realize more gains. Also, banks with negative earnings take big baths (avoid or reduce the earnings loss), if their unrealized gains are insufficient (sufficient) to offset the negative earnings. Our inferences apply to listed and non-listed banks, which indicates the earnings management incentives do not derive solely from public capital markets. Our findings reveal the accounting for AFS securities gains and losses enables banks to manage regulatory capital and earnings in a variety of ways.