The effect of taxes on small banks' loan loss provisions

So far the earnings management literature has failed to establish the impact of taxes on the Loan Loss Provisions (LLPs) of financial institutions. We extend the discretionary LLP literature to a less studied area regarding the role of taxes in determining the behaviour of LLPs in a sample of 300 small banks in the period 1990–2004. Due to tax provisions that allow small banks to use LLPs, we find support for the hypothesis that taxes affect banks' discretionary LLPs. This finding is contrary to the findings of the few studies on this subject (Beatty et al., 1995; Scholes et al., 1990) that, using large banks, find little or no linkage between taxes and LLPs. We find that banks that were likely to pay the Alternative Minimum Tax (AMT) tended to lower their LLP. In addition, low Marginal Tax Rate (MTR) banks tend to have greater LLP than high MTR banks. Although the results may not be generalisable to the general population of banks and because LLPs are a large proportion of banks' income, these findings are important for bank regulators and analysts who may want to analyse LLP drivers.