Journal of Islamic Accounting and Business Research

The determinants of loan loss and allowances for MENA banks: Simultaneous equation
and three-stage approaches
Dennis Olson Taisier A. Zoubi

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Dennis Olson Taisier A. Zoubi , (2014),"The determinants of loan loss and allowances for MENA banks",
Journal of Islamic Accounting and Business Research, Vol. 5 Iss 1 pp. 98 - 120
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JIABR
5,1

98

The determinants of loan loss and

allowances for MENA banks
Simultaneous equation and three-stage
approaches
Dennis Olson
School of Business and Economics, Thompson Rivers University,
Kamloops, Canada, and

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Taisier A. Zoubi
School of Business and Management, American University of Sharjah,
Sharjah, United Arab Emirates
Abstract

Journal of Islamic Accounting and

Business Research
Vol. 5 No. 1, 2014
pp. 98-120
q Emerald Group Publishing Limited
1759-0817
DOI 10.1108/JIABR-07-2013-0027

Purpose This study aims to examine the determinants of the allowance for loan losses (ALL) and
loan loss provisions (LLP) for banks in the Middle East and North African (MENA) region using both
a two-stage approach and simultaneous equation system to address the potential problem of
estimation bias introduced by estimating the ALL and LLP separately. The paper also tests three
competing hypotheses: the earnings management hypothesis, the capital management hypothesis, and
the signaling hypothesis.
Design/methodology/approach The authors adopt a simultaneous equation and three-stage
approaches to test whether MENA banks jointly determine LLP and ALL and the determinants of the
two accounts. The sample consists of all available electronic data for 75 banks (451 bank-year
observations) in nine MENA countries over the period 2000-2008.
Findings Evidence suggests that the two accounts are jointly determined. The results support the
earnings management hypothesis meaning that MENA banks have engaged in year-to-year income
smoothing. The authors also find that LLP and ALL provide signals about future earnings.
Research limitations/implications The authors acknowledge that the LLP account is only one
of many accounts on the income statement that could be used for signaling or to manage earnings, and
that the ALL is one of several accounts that could be used for signaling, earnings or capital
management. Future studies could examine other accruals for their role in managing earnings,
signaling and capital.
Practical implications The results indicate that bank managers use LLP and ALL accounts to
manage earnings management, policy makers may want to limit the ability of banks to manipulate
earnings.
Originality/value Prior research on the loan loss accounting practices has been based on single
equation models of the determinants of LLP and ALL. An issue that has not been adequately addressed in
this literature is that ALL and LLP may be interrelated and jointly determined by banks. If the
two accounts are not independent of each other, failure to include one when estimating the other may lead
to an omitted variable problem, while including both in the same equation induces a potential simultaneity
bias. The study is the first empirical work examining whether ALL and LLP are jointly determined by
banks. By jointly estimating LLP and ALL, the study permits an assessment of the magnitude of the
potential error from adopting ordinary least squares estimation of a single equation model.
Keywords Earnings management, Capital management, Loan loss allowances, Loan loss provisions,
MENA banks
Paper type Research paper

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1. Introduction
Allowance for loan losses (ALL) and loan loss provisions (LLPs) are among the most
important items reported on bank financial statements due to the size of these accounts
and the potential impact on reported net income, total assets, and equity.
The ALL account conveys information about expected future losses in a banks loan
portfolio and/or its ability to absorb such losses without harming depositors. ALL is a
contra account that reduces assets reported on the balance sheet, while LLPs involve
accrued expenses reported on a banks income statement. LLPs replenish the ALL
account on the balance sheet usually on a quarterly or annual basis. Both ALL and
LLPs potentially provide signals about future profitability, but bank management has
considerable discretion over how to use these accounts. Increases in provisions reduce
reported annual earnings and can be used to smooth earnings, while increases in
allowances reduce total assets and consequentially reduce shareholder equity. Studies,
such as Wall and Koch (2000) and Hasan and Wall (2004), argue that many banks use
loan loss accounting practices to manage earnings and/or capital, while Ahmed et al.
(1999) and Anandarajan et al. (2007) have tested whether banks use loan loss accounts
for signaling purposes, in addition to earnings and capital management.
Prior research on the discretionary components of loan loss accounting practices has
been based on single equation models of the determinants of LLP, and to a lesser extent
on the determinants of ALL. While Anandarajan et al. (2007) and Fonseca and Gonzalez
(2008) include ALL as an independent variable when estimating LLPs, studies such as
Ahmed et al. (1999) and Bikker and Metzemakers (2005) do not consider ALL in the
determination of LLP. Similarly, Beaver and Engel (1996) and Hasan and Wall (2004) do
not include LLP in the estimation of the ALL equation, while Gray and Clarke (2004)
proposed using LLP as an explanatory variable to determine ALL. An issue that has not
been adequately addressed in this literature is that ALL and LLP may be interrelated
and jointly determined by banks. If the two accounts are not independent of each other,
failure to include one when estimating the other may lead to an omitted variable
problem, while including both in the same equation induces a potential simultaneity
bias. This simultaneity issue can be partially mitigated using a lagged value of ALL in
the LLP equation; however, if the two accounts are truly jointly determined, two-stage
and three-stage least squares can provide more precise estimates of ALL, LLP, and the
determinants of these two variables. For example, Beaver et al. (2012) used a two-stage
procedure to jointly estimate earnings and stock returns. Similarly, the accounting
variables that determine ALL (excluding LLP) and the accounting variables that
determine LLP (excluding ALL) can be estimated by a first-stage ordinary least square
(OLS) regression. In the second stage, the predicted values of ALL can be used to
estimate LLP and the predicted values of LLP can be used to estimate ALL. These two
equations are estimated separately under two-stage least squares, while three-stage
least squares estimates the dependent variables (ALL and LLP) simultaneously within a
system of equations. Kennedy (2008) notes that three-stage least squares is often (but not
always) more efficient than two-stage least squares meaning that three-stage
techniques usually provide more precise estimates of regression coefficients than the
two-stage estimates. In general, three-stage least squares should be more efficient than
two-stage estimation in large samples whenever the endogenous variables (ALL and
LLP) are highly correlated with the error or disturbance term of the regression. Since we
believe that the two variables may be jointly determined, three-stage estimation is likely

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to provide more accurate estimates of the regression coefficients than two-stage

estimation. Therefore, it is useful to consider the results from both two-stage and
three-stage estimation procedures and to compare them with the potentially biased
results from OLS estimation.
This paper examines the determinants of LLPs and loan loss allowances for Middle
East and North African (MENA) banks[1]. The MENA region has grown rapidly in
recent years, in terms of both population and income. Despite the importance of the
LLPs and allowance for banks in the MENA region, to our knowledge there has been
no research to date on this region. Previous academic research on this topic has focused
on banks in Latin America, North America, Europe, or the Far East. Taxes play a
smaller role than in other areas and this region contains a disproportionately larger
percentage of Islamic banks than other parts of the world. Islamic banks rely more on
participatory financing than conventional banks, yet they must compete with
conventional banks. Similarly, the lending practices of conventional banks in the
MENA region may have to adapt to compete with Islamic bank financing instruments.
For these reasons, loan loss accounting practices in the MENA region could be
different than those observed in Europe or North America and our results should be of
considerable interest to policy makers in the MENA region.
The primary goal of this paper is to test whether LLPs and allowances are determined
independently, or if the level of ALL affects LLP. This is also an indirect test of whether
MENA banks follow an income statement approach of setting aside provisions each year
based on current period loans issued, or whether they adopt a balance sheet approach
where LLPs depend upon the beginning balance of the ALL account and current period
loan write-offs and recoveries. Secondarily, the paper also tests three competing
hypotheses about loan loss accounting practices in the MENA region. Following
Ahmed et al. (1999) and Anandarajan et al. (2007), we examine and test:
(1) the earnings management hypothesis;
(2) the capital management hypothesis; and
(3) the signaling hypothesis for MENA banks.
Our tests take account of simultaneity and we compare our results with those from
traditional single equation models used in previous research. Our findings indicate that
banks in the MENA region use loan loss accounting practices to smooth income, but
not to manage capital. Loan loss allowances and provisions are both positively related
to future non-performing loans showing that banks do correctly anticipate future
non-performing loans. However, our results provide mixed support for the two
earnings signaling hypotheses. Higher loan loss allowances do signal higher future
earnings, but higher LLPs are a negative signal about future earnings.
Our study makes several contributions to the extant literature on loan loss
accounting. It is the first empirical work examining whether ALL and LLP are jointly
determined by banks. By jointly estimating LLP and ALL, our study permits an
assessment of the magnitude of the potential error from adopting OLS estimation of a
single equation model. Second, our study investigates the use of loan loss accounting
practices to manage earnings and capital, and/or as a signaling device for banks in the
MENA region an important area where banking practices have not yet been
extensively analyzed.

The remainder of this paper is organized as follows. Section 2 discusses loan loss
accounting and Section 3 provides a brief review of the literature on loan loss
accounting practices and develops hypotheses for testing. Section 4 explains our
methodology and Section 5 discusses the data. Section 6 presents our results about our
primary hypothesis and the three secondary hypotheses tested in our paper, while
Section 7 makes some concluding remarks.

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2. Accounting for allowance for doubtful loans and LLP
There are two accounting methods for recognizing uncollectible loans the balance
sheet approach and income statement approach. Under the income statement
approach, emphasis is placed on the LLPs. Banks estimate LLP for the current period
as a percentage of total loans generated during the current period. The beginning
balance of the ALL is adjusted downward by the actual amount of loans written off
and adjusted upward by the amount of loans recovered (loans recovered in the current
period that had been written off in previous periods). The resulting balance of ALL is
then adjusted upward by the amount of the current period LLPs. Under the income
statement approach, LLP for the current period is independent of the beginning
balance of ALL, write-offs and loan recovery. The beginning balance of the allowance
account should reflect the estimated amount of prior periods loans that will not be
collected in the future periods. Nevertheless, changes in the collectability of some of
their loans may induce banks to revise the beginning balance of allowances either
upward or downward. As a result a bank may increase or decrease LLP for the current
period. In other words, LLPs consist of two components under this approach: the
estimated uncollectible amount of loans originated during the current period and
the revision of the uncollectible amount of loans originated during prior periods. The
income statement approach places greater emphasis on the amount of LLPs that
should be recognized in the income statement to achieve certain objectives such as
earnings management (to smooth income, provide management bonuses, etc.). The
income statement approach properly match expenses (LLPs) with revenues generated
(interest income) for the current period. Under this approach, the amount of ALL
presented in the balance sheet is an indirect result of estimating LLPs.
Under the balance sheet approach, bank management estimates the target balance
in the ALL account based on the outstanding balance of loans at the end of the year
(although banks may group loans based on their ages and take a higher percentage
from older loans). Following this approach, banks set a target for end of the period ALL
and this number depends upon the beginning of the period ALL, actual write offs and
loan recoveries, and LLPs. That is, the balance sheet approach takes account of more
information than the income statement approach, but at the expense of being more
difficult to implement. The balance sheet approach does not achieve proper matching
of expenses (LLPs) with revenues (interest income) generated in the current period.
Using the balance sheet approach, LLP is an incidental outcome of estimating the net
realizable value of loans (loans minus ALL). This approach places heavy emphasis on
the balance of ALL that can be used to achieve several objectives such as, producing
a conservative balance sheet ( Jackson and Liu, 2010), meeting minimum capital
requirements, and managing earnings.
Regarding the relative merits of the two approaches, Beaver and Engel (1996) have
documented that the income statement approach is not superior to the balance

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sheet approach. By examining the ALL, users of the financial statements will be able to
value the banks and evaluate the performance more accurately. Banks regulators
focus on the capital adequacy of banks which use ALL rather than the LLPs.
Regulators allow the use of portion of the ALL in Tier II capital calculation. Auditors of
banks are also concerned with the adequacy of the ALL. Items presented in the balance
sheet are frequently used in the valuation and evaluation of banks. Barth et al. (1996)
argued that stock market participants use information presented in bank balance
sheets more than the items presented in their income statements.
Due to the various conflicting objectives that can be achieved by either the income
statement approach or the balance sheet approach, banks may utilize a mixture of the
two approaches to accomplish different objectives. That is, banks may jointly estimate
LLPs and the ALL.
After reviewing the financial statements and the footnotes disclosures of banks in
the MENA region, we found that banks in the MENA region adopted the financial
accounting rules established by the International Accounting Standards Board. The
exception is that banks in Egypt have adopted their own national accounting
standards. Differences regarding the level and extent of footnote disclosure among
banks exist. However, accounting methods used to calculate ALL and LLP appear to be
similar, even though the estimation processes for ALL and LLP are internal to each
bank and not easily observable by outside users of the financial statements.
Irrespective of which standards banks use to determine ALL and LLP, banks in the
MENA region disclose the following items in the footnotes that accompany their
financial statements:
.
The beginning and ending balances for ALL for the current year and previous
year.
.
Changes in ALL during the current period and previous period. Banks disclose
separately the amount recognized as an expense in the period for losses on
uncollectible loans and advances, the amount written off, and the amount
credited in the period for loans and advances previously written off that have
now been recovered.
.
The aggregate amount of nonperforming loans on the date the balance sheet is
prepared on which interest is not being accrued for the current and/or the
previous period.
3. Literature review and hypothesis development
Bank management uses its discretion over items reported in the financial statements to
achieve various objectives. These objectives include the desire to reduce risk (or make
it appear that a bank is less risky), ensure capital adequacy, meet contract
requirements (e.g. debt covenants and compensation contracts), smooth reported
income, and signal information about loans and its ability to take additional future
charges against capital. By doing so, bank management influences wealth transfers
and redistribution among the different groups of stakeholders (stockholders,
bondholders, management) (Watts and Zimmerman, 1986). There are many items
reported in the financial statements that management can influence such as
depreciation, pensions, leases, and inventory. These items have both a discretionary

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and a nondiscretionary component and two of the most important of such items
reported in bank financial statements are the ALL and LLPs.
Quite a substantial body of evidence about discretionary loan loss accounting
practices has appeared in the accounting and finance literature. For example, Wall and
Koch (2000) have extensively reviewed the literature and examined the philosophy
behind the practices. They concluded that many banks have used the loan loss
accounts for capital and earnings management objectives. Ahmed et al. (1999) have
suggested that banks may have a third possible discretionary motive that they label
the signaling hypothesis. It suggests that LLPs are a signal of financial strength,
meaning that higher LLP indicates a bank can absorb a greater reduction in future
earnings. While Ahmed et al. (1999) have extensively tested these three theories for US
banks and Anandarajan et al. (2007) have provided a similar test for Australian banks,
these theories have not been examined for MENA banks.
3.1 Balance sheet determination of LLPs
While many studies have examined the three hypotheses mentioned above, a more
important first step before examining these theories may be to test whether banks follow
a balance sheet or income statement approach to determining LLPs in each year. Since we
believe, based on the results of the prior empirical work, that the ALL and LLP accounts
are interrelated and jointly determined, the first hypothesis to test in our paper is:
H1. MENA banks follow a balance sheet approach to allocating annual LLPs.
This hypothesis will be examined by estimating the determinant of ALL and LLP in
two separate equations using OLS procedures. Second, when using systems methods,
if a simultaneous system of ALL and LLP equations is a significant improvement over
two single equation models used to identify the determinants ALL and LLP, then the
evidence would indicate that the two accounts are jointly determined. To date, ALL
and LLP have not been estimated by three-stage least squares in a simultaneous
system, but some papers have adopted a two-stage approach for separating the
discretionary component of ALL or LLP from its non-discretionary part. For example,
Beaver and Engel (1996) adopted a two-stage approach to examine the effect of ALL on
the market value of US banks for the period 1977-1991. In the first stage, they regressed
ALL on non-performing loans, net charge-off of loans, and total loans. In the second
stage, the estimated error from the first-stage discretionary component of ALL was
used to explain the market value of equity. The results of their study showed that total
loans, loans charge-offs, and nonperforming loans were statistically significant
variables in explaining the non-discretionary part of the ALL. The results also show
that the non-discretionary component of the ALL had a negative effect on the market
value of equity, while the discretionary part had a positive effect on stock prices.
Kanagertnam et al. (2004) utilized a similar two-stage approach to distinguish between
the non-discretionary and discretionary components of LLP for US banks over the
period 1992-2001. In our paper, the balance sheet approach to determining LLP is
favored if predicted first-stage values of ALL affect the magnitude of LLP.
3.2 Earnings management hypothesis
According to the earnings management hypothesis banks managers can smooth
income and reduce the volatility of earnings over time by increasing LLPs during good

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years and decreasing LLPs in bad years. A substantial body of literature (McNichols
and Wilson, 1988; Kim and Santomero, 1993; Bhat, 1996; Healy and Wahlen, 1999; Lobo
and Yang, 2001; Fonseca and Gonzalez, 2008) have shown that commercial banks use
LLPs to smooth income, while Wall and Koch (2000), Beatty et al. (2002) and Jackson
and Liu (2010) found that managers smooth income via the ALL account. In contrast,
Ahmed et al. (1999) found no evidence that US banks engaged in earnings management
during the period 1986-1995. Following the work of Ahmed et al. (1999) and
Anandarajan et al. (2007) the earnings management hypothesis can be tested for
MENA banks by observing whether earnings are positively correlated with LLP and
ALL, as predicted by this hypothesis. Hence, our second hypothesis to test earnings
management is:
H2. There is a positive relationship between LLPs and/or loan loss allowances and
current earnings before LLPs and taxes.
3.3 Capital management hypothesis
Under the Basel Accord of 1998, which provides guidelines for international banking,
banks must maintain a ratio of Tier I capital (which consists primarily of equity
capital) to assets of 3 percent or higher. Tier I capital must exceed 4 percent of
risk-weighted assets and Tier II capital (which includes loan loss reserves and various
types of long term debt) must exceed 8 percent of risk weighted assets. Within Tier II
capital, an allowance for doubtful loans of up to 1.25 percent of total risk weighted
assets is permitted. Thus, the capital management hypothesis is based on the idea that
banks having trouble meeting regulatory capital requirements can increase bank
capital by increasing LLP and therefore ALL, rather than by increasing bank equity
(which is quite costly). The capital management hypothesis suggests a negative
relationship between the equity to assets ratio (or other equity based ratios) and
allowances and provisions for loan losses. Our third hypothesis is:
H3. There is a negative relationship between LLPs and/or loan loss allowances
and measures of bank capital, such as the equity to assets ratio.
Prior research on the capital management hypothesis has provided mixed results. For
example, Lobo and Yang (2001), Beatty et al. (1995) and Moyer (1990) found that banks
engage in capital management, while Collins et al. (1995) concluded that banks did not
use loan loss accounts to manage capital. However, perhaps such contradictory results
should be expected because the Basel Accord that limits the use of ALL to 1.25 percent
of risk-weighted assets took effect in 1990, meaning that incentives for capital
management were much greater prior to 1990, than after 1990.
3.4 Signaling hypothesis
Whalen (1994) contended that managers can signal that future cash flows of the bank
will be improved by increasing the current period discretionary component of the ALL.
Ahmed et al. (1999) label this idea as the signaling hypothesis. It states that banks
signal their financial strength through the use of LLPs, meaning that increases in LLP
forecast positive changes for future earnings. However, they found that the opposite
occurred for US banks, as did Anandarajan et al. (2007) for Australian banks. Perhaps
a more plausible hypothesis is that banks increase LLP and ALL because they expect
increases in nonperforming loans and problems in the future. In line with these views,

Musumeci and Sinkey (1990) argue that additions to ALL are a negative signal about
loan quality, indicating that a bank may have to accept less than the full value of the
loan in the future. Our fourth hypothesis for MENA banks therefore consists of the
two diametrically opposed views of signaling:
H4A. LLPs and/or allowances are positively related to one-year-ahead changes in
bank earnings as predicted by signaling theory.

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Higher allowances this year will lead to lower provisions next year, so banks may
reverse some of the allowance next year (recognizing revenue). This will lead to higher
earnings next year. Thus, changes in earnings will be positive as shown by Jackson
and Liu (2010):
H4B. LLPs and/or allowances are negatively related to one-year-ahead changes in
bank earnings because they anticipate future problems with non-performing
loans.
To summarize, H4A states that allowances and provisions are a positive signal, while
H4B states that ALL and LLP are a negative signaling device.
Another type of signaling test is whether loan loss allowances and provisions signal
information about the quality of loans and the likelihood of future problems with
non-performing loans. We would expect banks to anticipate future problems with
non-performing loans through their loan loss accounting practices and we hypothesize:
H5. The higher (lower) the current level of LLPs and/or allowances, the higher
(lower) the future levels of non-performing loans.
The review of the prior literature indicates that variables used to explain the ALL are
somewhat similar to those used to examine LLPs. It appears that some banks smooth
income while others do not. Similarly, capital management is found in some studies
and not in others, while signaling has generally not been supported. Although we
expect that the contradictory evidence about earnings management, capital
management, and signaling is country and time period specific, one possible source
of bias in studies the simultaneity problem between ALL and LLP is addressed in
the following sections.
4. Methodology
Prior research has produced a variety of models that examine the determinants of ALL
and LLP based on single-equation estimation of either ALL or LLP. If banks generally
follow an income statement approach to determining LLPs, this single equation
approach is appropriate. However, if banks follow a balance sheet approach where LLP
is determined, in part, by the level of ALL, then either a two stage or a simultaneous
equation system is needed to more accurately identify the determinants of provisions
and allowances (Larcker and Rusticus, 2010).
If ALL and LLP are jointly determined by banks, failure to include one when
estimating the other leads to an omitted variable problem, while including both in the
same equation induces a potential simultaneity bias. One possible solution to the
simultaneity problem is estimation by a two-stage procedure developed by Beaver et al.
(2012) for jointly estimating earnings and stock returns. A second choice is to use
three-stage least squares to estimate a system of two simultaneous equations involving

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LLP and ALL as dependent variables. Since Kennedy (2008) and Larcker and Rusticus
(2010) note that three-stage least squares is often (but not always) superior to two-stage
least squares, it is useful to consider the results from both estimation procedures and to
compare them with the potentially biased results from OLS estimation.
4.1 Two-stage approach to estimating ALL and LLP
Adopting a variant of the Beaver et al. (2012) two-stage procedure for jointly
estimating earnings and stock returns, we estimate two single-equation OLS models
for the ALL and LLPs. Each dependent variable is scaled to account for bank size,
so that end of period allowances and provisions as a percentage of net loans are
represented by ALLt and LLPt. In the first stage, each dependent variable is
estimated as a function of five exogenous variables (also appropriately scaled for
bank size) that have been used in other studies to explain allowances and provisions.
The first-stage regression model is:
ALLt a1 a2 WROt a3 NPLt21 a4 CNPLt a5 INFLt a6 LSIZEt
a7 GOVt a8 TYPE a9 DEGYPT a10 DJORDAN e1t
LLPt a11 a12 WROt a13 NPLt21 a14 CNPLt a15 INFLt a16 LSIZEt
a17 GOVt a18 TYPE a19 DEGYPT a20 DJORDAN e2t

The variables and notation are defined as follows:

ALLt

end of period allowance for loan losses/end of period net loans.

LLPt

current period loan loss provisions/end of period net loans.

WROt

net loan write-offs in the current period (actual loan write-offs loan
recoveries)/net loans.

NPLt2 1 beginning of period non-performing loans.

CNPLt

the percent change in total non-performing over the current period.

INFLt

current period inflation rate.

LSIZEt

log of size as measured by the natural log of a banks total assets.

GOV

percentage of banks shares owned by the government.

TYPE

0 if the bank is conventional, 1 if Islamic.

DEGYPT 1 if the bank is Egyptian, 0 otherwise.

DJORDAN 1 if the bank is Jordanian, 0 otherwise.
a1-a20

regression parameters.

e1t, e2t

error terms.

The resulting estimates for each bank for each year are then saved as predicted values
of the dependent variable at time t[2]. Also, note that since non-performing loans are
highly correlated with both ALL and LLP, inclusion of current values of NPLt in
equations (1) and (2) would introduce simultaneity bias into the estimation procedure.

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To somewhat mitigate this problem, lagged values of these variables (NPLt2 1 and
CNPLt) are instead used as explanatory exogenous variables in the ALL and LLP
equations.
The second stage of this procedure involves OLS estimation of both ALL and LLP.
In equation (3), the predicted value of LLP (predLLP) obtained from equation (2) along
with an earnings to assets ratio (ERNt) and an equity to assets ratio (EQUt2 1) are used
to estimate ALLt. Similarly, in equation (4) the predicted value of ALL (predALL) and
ERNt and EQUt2 1 are used to estimate LLPt as follows:
ALLt b1 b2 predLLPt b3 ERNt b4 EQUt21 e3t

LLPt b5 b6 predALLt b7 ERNt b8 EQUt21 e4t :

The variables and notation for equations (3) and (4) are:
predLLPt predicted value of loan loss provisions for period t (scaled by net
loans).
predALLt predicted end of period value of the loan loss allowance account
(scaled by net loans).
ERNt

current period earnings before taxes and loss provisions/beginning of

period total assets.

EQUt2 1

beginning of period total equity/beginning of period total assets.

b1-b8

regression parameters.

e3t, e4t

error terms[3].

The primary test of the income statement versus balance sheet approach for
determining provisions depends upon whether the regression parameter b6 is
significant. A significant b6 coefficient supports the balance sheet approach, while an
insignificant coefficient is more consistent with the income statement approach.
Supporting evidence is obtained by noting the significance of the b2 parameter (where
significance again supports a balance sheet approach). The earnings management
hypothesis can be examined by noting the sign and statistical significance of the b3
and b7 coefficients on the earnings variable (ERN). If a bank is smoothing income, we
expect that b3 . 0 and b7 . 0.
To meet the capital requirement of the Basel Accord, the capital management
hypothesis suggests that managers of banks with low regulatory capital will have
incentives to increase LLPs and thereby increase the balance of ALL account. Bank
capital includes equity, ALL, preferred stocks, and mandatory convertible debt.
However, the primary source of bank capital for MENA banks is equity, which we
measure with the EQU variable[4]. If the capital management hypothesis is correct, total
equity will be negatively related to ALL and LLP meaning that b4 , 0 and b8 , 0.
4.2 Three-stage estimation of ALL and LLP
Three-stage least squares is the systems counterpart of two-stage least squares. It uses
the same variables as in the two-stage procedure, but treats both ALLt and LLPt as
dependent variables in a system of two simultaneous equations as follows:

Determinants of
loan loss and
allowances
107

JIABR
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ALLt a1 a2 WROt a3 NPLt21 a4 CNPLt a5 INFLt a6 LSIZEt a7 GOVt

a8 TYPE a9 ERNt a10 EQUt21 a11 DEGYPT a12 DJORDAN e5t
5
LLPt a13 a14 WROt a15 NPLt21 a16 CNPLt a17 INFLt a18 LSIZEt

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108

a19 GOVt a20 TYPE a22 ERNt a23 EQUt21 a24 DEGYPT
a25 DJORDAN e6t

In the first stage, both equations are estimated individually by OLS regressions. Then,
estimated values from the first stage are used as instrumental variables in the second
stage. Finally, correlations between the errors across the second-stage equations are
incorporated into the variance-covariance matrix for the system of equations in the
third stage. If the variance-covariance matrix is diagonal, the three-stage results are
identical to two-stage results. However, if this matrix is non-diagonal as shown by a
likelihood test, then three-stage results are preferred to two-stage estimation and also
the systems approach is preferable to independent estimation of ALL and LLP by OLS
equations.
4.3 OLS regression model
To contrast with two-stage and three-stage least squares results, we also estimate
equations (5) and (6) using OLS. These are the first-stage results in the three-stage least
squares estimation procedure. The coefficients are of the same sign in the first and
third stages, but some t-statistics are quite different. On average, OLS coefficients
appear more significant than they should be when simultaneity is properly taken into
account.
4.4 Test of signaling
The signaling H4A and H4B can be tested by modifying either the two-stage approach
in equations (1)-(4) or the three-stage model of equations (5) and (6) to see the
relationship between current allowances and provisions and either future earnings or
the percentage change in earnings in the next period (CERN ). Since results are
similar using future ERN or CERN or between two-stage and three-stage least
squares, only the two-stage results for CERN are presented and the models are
represented as:
ALLt21 a1 a2 WROt21 a3 NPLt22 a4 CNPLt21 a5 INFLt21 a6 LSIZEt21
a7 GOVt21 a8 TYPE a9 EQUt22 a10 DEGYPT a11 DJORDAN e1t
7
LLPt21 a12 a13 WROt21 a14 NPLt22 a15 CNPLt21 a16 INFLt21
a17 LSIZEt21 a18 GOVt21 a19 TYPE a20 EQUt22

a21 DEGYPT a22 DJORDAN e2t

ALLt21 b1 b2 predLLPt b3 CERNt e3t

LLPt21 b4 b5 predALLt b6 CERNt e4t :

10

Note that ALL and LLP have been lagged one period, so that CERN represents the
change in future earnings. If b6 . 0, then LLPs are a signal of higher future earnings
and they are also a signal of financial strength and as predicted by the signaling
hypothesis. Secondary support could be obtained if b3 . 0 and it was statistically
significant in the ALL equation. A similar test can be performed using OLS with CERN
as the dependent variable and ALLt2 1 and LLPt2 1 as independent variables, as
follows:

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CERNt a1 a2 ALLt21 a3 LLPt21 a4 INFLt21 a5 TYPE e9t :

11

The signaling hypothesis suggests a negative relationship between CERN and

provisions and allowances. In contrast, a positive sign for these coefficients would
support H4B that higher values for provisions and allowances forecast future
problems and lower future earnings.
Another test of signaling is whether allowances anticipate future problems with
non-performing loans. A test of H5 that higher current levels of loan loss allowances
lead to higher one-year-ahead levels of non-performing loans can be expressed as
follows:
NPLt a1 a2 ALLt21 a3 LLPt21 a4 GCC a5 TRADED a16 DJORDAN e10t ;
12
where GCC 1 for GCC banks and 0 otherwise, and TRADED 1 if the bank is
publicly held and 0 otherwise.
A positive coefficient for a2 in equation (12) would indicate that higher allowances
anticipate problems with higher levels of future non-performing loans.
5. Sample description
To examine the research questions, data were collected from three different sources.
The primary data source is the annual reports obtained from the web sites of the
various banks in our sample. These annual reports include the income statement,
statement of change in stockholders equity, balance sheet, statement of cash flows,
and the footnotes to the financial statements. Macroeconomic data involving gross
domestic product and inflation were taken from the DataStream database and from the
statistics of the International Monetary Fund (IMF)[5]. Our sample consists of all
available electronic data for 75 banks in nine MENA countries over the period
2000-2008. The countries include Bahrain, Egypt, Jordan, Kuwait, Lebanon, Oman,
Qatar, Saudi Arabia, and the United Arab Emirates. Our data set includes most of the
banks operating in these countries. Since the first year of data for each bank was used
to initialize lagged variables and to create variables involving year to year changes, the
final sample contains 451 bank-year observations for the period 2001-2008.
Table I provides the descriptive statistics for all the variables used in this study.
The average ALL as a percent of net loans is 6.9 and 3.0 percent of total assets. This
level of loan allowances is somewhat above the percentages found in most other
countries. For example, Hasan and Wall (2004) reported that the average ALL for the
USA and Japan was about 1.01 percent of total assets. The higher value for ALL in the
MENA region may indicate that its banks are following more conservative accounting
practices than in other countries. Alternatively, MENA banks may simply be more

Determinants of
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allowances
109

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JIABR
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Variable

Mean

SD

Minimum

Maximum

110

ALLt
LLPt
WROt
NPLt
CNPL
INFLt
LSIZEt
ERNt
CERN
EQUt2 1

0.069
0.012
0.004
0.065
2 0.004
3.691
15.380
0.032
0.007
0.130

0.072
0.013
0.017
0.069
0.049
3.358
1.234
0.015
0.021
0.058

0.003
0.000
20.042
0.000
20.487
21.219
12.586
20.030
20.041
0.031

0.470
0.134
0.168
0.518
0.209
13.764
18.158
0.508
0.370
0.398

Table I.
Descriptive statistics for
variables in regressions

Notes: n 451; where: ALLt allowance for loan losses at end of period/end of period net loans,
LLPt loan loss provisions/end of period net loans, WROt net write-offs (actual loan write-offs
loan recoveries)/net loans, NPLt non performing loans/total loans, CNPL change in
non-performing loans, INFLt inflation rate within a country, LSIZEt natural log of total assets,
ERNt earnings before tax and loan losses/beginning of period total assets, CERN percent change
in ERN, EQUt2 1 beginning of period total equity/beginning of period total assets

worried about future nonperforming loans than banks in other countries. The range for
ALL is from 0.3 up to 47 percent of net loans, indicating quite a difference between
practices and expectations about the future among MENA banks. Similarly, the
average annual LLP of 1.2 percent of net loans has a large range from nearly zero to
13.4 percent of net loans. Non-performing loans average 6.5 percent of total loans, but
range from zero to 51.8 percent of net loans. The earning to assets (ERN) ratio (which is
a variant of return on assets) averages 3.2 percent and ranges from 2 3.0 up to
50.8 percent. Such numbers are in line with previous studies of profitability in
North America and Europe. The average equity to assets ratio (EQU) across all banks
is 13 percent with a range of 3.1-39.8 percent. The net write-off ratio for loans (WRO) of
0.4 percent of total assets is quite low compared with other countries. This may be due
to aggressive collection policies followed by banks in the MENA region and/or
stringent legal systems in these countries make it easier for banks to collect loans and
consequently have smaller loan write-offs.
Three additional summary ratios not used in subsequent regressions and not reported
in Table I may be useful for understanding the characteristics of MENA bank data. The
total loan to asset ratio averages 48 percent and is similar in magnitude to ratios presented
in other studies. The long-term debt to equity ratio averages about 2.0, but ranges from
zero to 9.86 exhibiting a greater range than in many other regions of the world. Finally,
the loans to deposits ratio averages 83.4 percent indicating that MENA banks rely more
heavily upon deposits as a source of funds than banks in other regions.
Table II presents the average simple correlation coefficients among ALL, LLP,
WRO, NPL, CNPL, INFL, LSIZE, ERN, CERN, and EQU. The correlation coefficients
among most independent variables are quite low, indicating few problems with
multicolinearity. The exception is the 87.9 percent correlation between the earnings to
asset ratio (ERN) and percent changes in this ratio (CERN) suggesting that the
variables ERN and CERN should not be used in the same regression. The average
correlation coefficients of 60.3 percent between ALL and NPL and 56.0 percent between
LLP and NPL suggest that the level of non-performing loans is perhaps the major

ALLt

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ALLt
LLPt
WROt
NPLt
CNPL
INFLt
LSIZEt
ERNt
CERN
EQUt2 1

LLPt

WROt

NPLt

CNPL

1.000
0.547
1.000
0.169
0.265
1.000
0.603
0.560
0.236
1.000
20.002
0.075 20.081
0.173
1.000
20.191 20.154 20.112 20.154 2 0.025
20.367 20.252 20.098 20.419
0.052
20.022
0.033 20.102 20.069 2 0.045
20.002
0.043 20.128 20.050 2 0.021
0.083 20.027 20.048 20.014
0.027

INFLt

1.000
0.130
0.119
0.019
0.179

LSIZEt

ERNt CERN EQUt2 1

Determinants of
loan loss and
allowances
111

1.000
0.078 1.000
0.043 0.879
20.196 0.351

1.000
0.146

1.000

Notes: n 451; where: ALLt allowance for loan losses at end of period/end of period net loans,
LLPt loan loss provisions/end of period net loans, WROt net write-offs (actual loan write-offs
loan recoveries)/net loans, NPLt non performing loans/total loans, CNPL change in
non-performing loans, INFLt inflation rate within a country, LSIZEt natural log of total assets,
ERNt earnings before tax and loan losses/beginning of period total assets, CERN percent change
in ERN, EQUt2 1 beginning of period total equity/beginning of period total assets

determinant of the amount of loan loss reserves allocated annually and over time by
MENA banks. Notice also that ALL and LLP are 54.7 percent correlated. Thus,
anticipated problems with doubtful loans persist over time so that high allowances
must be continually replenished with high provisions.
6. Empirical results
Tables III-VII present the regression results for the tests of our six hypotheses. Overall,
the evidence supports the balance sheet approach over the income statement approach
to formulating LLPs, suggests income smoothing, fails to support capital management,
and rejects signaling as it applies to future earnings.
Table III presents the results from the two-stage technique inspired by the work of
Beaver et al. (2012), as presented in equations (1)-(4). Non-performing loans (NPLt2 1)
and changes in non-performing loans (CNPL) are highly significant in determining
ALL and LLP in equations (1) and (2). Write-offs (WRO) are highly significant in
explaining loan loss provisions (LLPt), but not in the level of allowances (ALLt ).
Inflation (INFL) and size of the bank (LSIZE) are negatively related to allowances and
provisions, while greater government ownership (GOV) of a bank leads to smaller
LLPs. Islamic banks (TYPE 1) have set aside relatively smaller allowances as a
percent of assets than conventional banks, but the difference is not significant at the
10 percent significance level. Finally, the dummy variables for Egypt (DEGYPT) and
Jordan (DJORDAN) indicate that banks in Egypt set aside significantly more in a relative
sense for LLPs than banks in Lebanon or the GCC, while banks in Jordan have set aside
relatively less in both provisions and allowances than banks in Lebanon or the GCC.
In contrast, allowances and provisions appear to be determined in a similar manner
across the countries of the GCC and in Lebanon.
In the second-stage regressions, the coefficient of predALL, b6 0.156 in the LLP
equation (equation (4)) is significant at the 1 percent level, providing support for
H1 that MENA banks are more likely to follow a balance sheet approach to allocating
provisions than an income statement approach. Similarly, b2 5.537 in equation (3)

Table II.
Correlation coefficients
among variables

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112

Table III.
Results from two-stage
least squares

Independent variables

Dependent variable: ALLt

Parameters
t-statistics

Dependent variable: LLPt

Parameters
t-statistics

Panel A: first stage pooled OLS regression with exogenous dependent variables
Intercept
0.200
5.05 * * *
0.106
1.45
WROt
0.022
0.14
0.102
3.45 * * *
NPLt2 1
0.594
13.69 * * *
0.098
12.21 * * *
CNPL
0.448
7.41 * * *
0.093
8.32 * * *
INFLt
20.002
2 2.40 * *
2 0.001
2 1.78 *
LSIZEt
20.010
2 4.03 * * *
2 0.0003
2 0.56
GOVt
0.007
0.60
2 0.008
2 3.50 * * *
TYPEt
20.010
2 1.50
2 0.0002
2 0.17
DEGYPT
0.012
1.12
0.010
4.88 * * *
DJORDAN
20.049
2 5.86 * * *
2 0.006
2 3.93 * * *
R2
0.449
0.404
LLF
681.66
1,443.95
Panel B: second stage pooled OLS regression with predicted endogenous variables and the ERN and
EQU variables to test the income smoothing and capital management hypotheses
Intercept
20.015
2 1.36
0.001
0.676
Predicted LLP
5.537
14.12 * * *
Predicted ALL
0.156
9.99 * * *
ERNt
20.088
2 0.88
0.047
2.96 * * *
EQUt2 1
0.173
1.94 *
2 0.014
2 1.14
R2
0.396
0.350
LLF
660.68
1,424.64
Notes: Significant at: *10, * *5 and * * *1 percent levels; n 451; where: ALLt end of period
allowance for loan losses/end of period net loans, LLPt current period loan loss provisions/end of
period net loans, WROt net loan write-offs in the current period (actual loan write-offs loan
recoveries)/net loans, NPLt2 1 beginning of period non-performing loans, CNPL the percent change
in total non-performing over the current period, INFLt current period inflation rate, LSIZEt log of
size as measured by the natural log of a banks total assets, GOVt percentage of banks shares owned
by the government, TYPEt 0 if the bank is conventional, 1 if Islamic, ERNt earnings before tax and
loan losses/beginning of period total assets, EQUt2 1 beginning of period total equity/beginning of
period total assets, DEGYPT 1 if the bank is Egyptian, 0 otherwise, DJORDAN 1 if the bank is
Jordanian, 0 otherwise, LLF log-likelihood function

is significant at the 1 percent level and this coefficient further indicates an interdependence
between ALL and LLP. Taken together, the coefficients b2 . 0 and b6 . 0 can be used to
perform a Hausman test of exogeneity, as described in Larcker and Rusticus (2010). Since
both coefficients are highly significant at the 1 percent level, weak exogeneity between
LLP and ALL is rejected at the 1 percent level. That is, the null hypothesis of no
endogeneity problem is rejected, and ALL and LLP are endogenous variables that should
be estimated by either two-stage instrumental variables or perhaps by three-stage least
squares. Results of OLS regression of equation (2) with lagged ALL as an independent
variable in determining current LLP (not presented in Table III) also show significance for
ALLt2 1 at the 1 percent level[6]. This is further evidence that the level of allowances
affects provisions meaning that banks more likely follow a balance sheet approach than
an income statement approach to determining LLPs.
In Panel B of Table III, the coefficient for current earnings (ERN) in the second-stage
LLP equation (equation (4)) is b7 0.047. It is positive and significant at the 1 percent

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Independent variables
Intercept
WROt
NPLt2 1
CNPL
INFLt
LSIZEt
GOVt
TYPEt
ERNt
EQUt2 1
DEGYPT
DJORDAN
System R 2
Equation R 2
System LLF

ALLt equation
Parameters
t-statistics
3.28 * * *
0.23
14.06 * * *
7.46 * * *
2 3.19 * * *
2 2.86 * * *
0.53
2 1.94 *
0.11
2.56 * *
1.98 * *
2 5.28 * * *

0.145
0.036
0.600
0.443
2 0.003
2 0.008
0.006
2 0.013
0.010
0.135
0.023
2 0.004
0.577
0.459
2,148.99

LLPt equation
Parameters
t-statistics
0.010
0.107
0.097
0.094
2 0.0003
2 0.0003
2 0.007
2 0.0007
0.036
2 0.001
0.010
2 0.006

1.25
3.68 * * *
12.29 * * *
8.51 * * *
2 2.00 * *
2 0.56
2 3.30 * * *
2 0.56
1.97 * *
2 0.11
4.66 * * *
2 3.76 * * *

Determinants of
loan loss and
allowances
113

0.577
0.409
2,148.99

Notes: Significant at: *10, * *5 and * * *1 percent levels; n 451; system of two simultaneous
equations with ALLt and LLPt as dependent variables; where: ALLt end of period allowance for
loan losses/end of period net loans, LLPt current period loan loss provisions/end of period net loans,
WROt net loan write-offs in the current period (actual loan write-offs loan recoveries)/net
loans, NPLt2 1 beginning of period non-performing loans, CNPLt the percent change in total
non-performing over the current period, INFLt current period inflation rate, LSIZEt log of size as
measured by the natural log of a banks total assets, GOVt percentage of banks shares owned by the
government, TYPEt 0 if the bank is conventional, 1 if Islamic, ERNt earnings before tax and loan
losses/beginning of period total assets, EQUt2 1 beginning of period total equity/beginning of period
total assets, DEGYPT 1 if the bank is Egyptian, 0 otherwise, DJORDAN 1 if the bank is Jordanian,
0 otherwise, LLF log-likelihood function

level, which supports H2 in that MENA banks engage in earnings management, or

income smoothing. However, the coefficient for earnings is negative and insignificant
in the ALL equation meaning that earnings management is accomplished through
additions to allowances, and not by managing the balances in the allowance account.
Similarly, Jackson and Liu (2010) have shown that firms outside the banking industry
can smooth earnings by manipulating the beginning balance of the allowance for
doubtful accounts. The balance can be increased by adding bad debt expense, or
deceased by recognizing certain revenues.
In Panel B of Table III, the coefficient for EQUt2 1 is insignificant in the LLP equation,
but it is positive and significant at the 10 percent level in the ALL equation. This positive
relationship between loan loss allowances and equity capital as measured by EQUt2 1 is
the opposite of what is predicted by H3, the capital management hypothesis. Hence,
MENA banks do not appear to use allowances and provisions to manage bank capital
and our results are consistent with Alali and Jaggi (2011) who found that US banks do
not engage in capital management. A possible explanation for the insignificance of the
capital management results is that banks in the MENA region experienced an economic
boom during the period of this study. Since banks were well capitalized during the
period of this study, there has been no need for banks to increase allowances
or provisions to meet Basel II capital requirements. According to Hasan and

Table IV.
Results from three-stage
least squares

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114

Table V.
Estimation by pooled
single equation OLS

Independent variables
Intercept
ALLt
LLPt
WROt
NPLt2 1
CNPL
INFLt
LSIZEt
GOVt
TYPEt
ERNt
EQUt2 1
DEGYPT
DJORDAN
R2
LLF

ALLt equation
Parameters
t-statistics
0.130

3.01 * * *

1.478
20.122
0.456
0.305
20.002
20.007
0.017
20.012
20.042
0.136
0.008
20.036

5.96 * * *
2 0.79
9.49 * * *
4.88 * * *
2 2.70 * * *
2 2.77 * * *
1.45
2 1.83 *
2 0.45
2.65 * * *
0.71
2 4.28 * * *
0.499
702.96

LLPt equation
Parameters
t-statistics
0.003
0.051

0.35
5.96 * * *
3.71 * * *
7.21 * * *
6.25 * * *
2 1.14
0.23
2 3.53 * * *
2 0.03
1.98 * *
2 0.83
4.20 * * *
2 2.30 * *

0.106
0.007
0.071
2 0.0002
0.0001
2 0.075
2 0.000
0.035
2 0.008
0.009
2 0.004
0.453
1,463.59

Notes: Significant at: *10, * *5 and * * *1 percent levels; n 451; ALLt and LLPt are dependent
variables, without taking account of simultaneity; where: ALLt end of period allowance for loan
losses/end of period net loans, LLPt current period loan loss provisions/end of period net loans,
WROt net loan write-offs in the current period (actual loan write-offs loan recoveries)/net loans,
NPLt2 1 beginning of period non-performing loans, CNPL the percent change in total nonperforming over the current period, INFLt current period inflation rate, LSIZEt log of size as
measured by the natural log of a banks total assets, GOVt percentage of banks shares owned by the
government, TYPEt 0 if the bank is conventional, 1 if Islamic, ERNt earnings before tax and loan
losses/beginning of period total assets, EQUt2 1 beginning of period total equity/beginning of period
total assets, DEGYPT 1 if the bank is Egyptian, 0 otherwise, DJORDAN 1 if the bank is Jordanian,
0 otherwise, LLF log-likelihood function

Wall (2004, p. 136), A healthy bank does not need to use its loan loss accounting
to manage its equity capital and attempting to do so may provoke an adverse
supervisory response.
Table IV presents the results from a simultaneous equation system estimated by
three-stage least squares. ALL and LLP as the dependent variables as shown in
equations (5) and (6). The three-stage estimation of the system of equations has some
advantages over two-stage least square regressions, but its disadvantage is that it does
not use the panel estimator to better take advantage of the panel nature of data.
Nevertheless, a likelihood ratio test of a diagonal variance-covariance matrix which is
tested with a x 2-statistic produces a value of 68.0. It is significant at the level of
0.01 percent, meaning that the diagonal matrix is rejected and that errors from the ALL
and LLP equations are highly correlated and systems estimation is preferred to estimation
of two individual equations for ALL and LLP. Also, the system R 2-statistic of
57.71 percent is higher than the R 2-statistics in Table III for either OLS or two-stage
regressions. The three-stage results suggest simultaneity between ALL and LLP
and provide additional support for H1 that MENA banks adopt a balance sheet approach
that takes account of a banks allowances for loan losses when determining annual LLPs.
The coefficients and significance levels in Table IV for the ERN and EQUt2 1
coefficients are reasonably consistent with the similar coefficients estimated in the

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Independent variables

Parameters

t-statistics

Parameters

t-statistics

Panel A: first stage pooled OLS regression with exogenous independent variables
Dependent variable: ALLt
Dependent variable: LLPt
Intercept
0.096
2.35 * *
0.095
1.36
WROt
0.246
1.36
0.089
3.00 * * *
NPLt2 1
0.558
10.65 * * *
0.093
10.82 * * *
CNPL
0.395
5.23 * * *
0.088
7.19 * * *
INFLt
0.001
0.51
2 0.000
2 0.34
LSIZEt
2 0.004
2 1.58
2 0.000
2 0.18
GOVt
0.004
0.28
2 0.012
2 5.05 * * *
TYPEt
2 0.013
2 1.54
2 0.002
2 1.31
EQUt2 1
0.093
1.56
2 0.005
2 0.53
DEGYPT
0.008
0.57
0.012
5.15 * * *
DJORDAN
2 0.044
2 4.18 * * *
2 0.005
2 3.13 * * *
R2
0.285
0.344
LLF
581.00
1,398.70
Panel B: second stage pooled OLS regression with predicted endogenous variables and changes in
future earnings (represented by CERN) to test the signaling hypothesis
Dependent variable: ALLt2 1
Dependent variable: LLPt2 1
Intercept
0.017
2.24 * *
0.001
0.30
PredLLPt
4.658
7.68 * * *
PredALLt
0.162
7.35 * * *
CERN
0.238
2.07 *
2 0.036
2 1.87 *
R2
0.218
0.262
LLF
560.79
1,371.91
Notes: Significant at: *10, * *5 and * * *1 percent levels; n 451; results obtained using two-stage
least squares with ALLt and LLPt as dependent variables; signaling is measured by the relationship
between the allowances and provision variables and changes in future earnings as estimated in the
second stage; where: ALLt end of period allowance for loan losses/end of period net loans, LLPt
current period loan loss provisions/end of period net loans, WROt net loan write-offs in the current
period (actual loan write-offs loan recoveries)/net loans, NPLt2 1 beginning of period
non-performing loans, CNPLt the percent change in total non-performing over the current period,
INFLt current period inflation rate, LSIZEt log of size as measured by the natural log of a banks
total assets, GOVt percentage of banks shares owned by the government, TYPEt 0 if the bank is
conventional, 1 if Islamic, EQUt2 1 beginning of period total equity/beginning of period total assets,
DEGYPT 1 if the bank is Egyptian, 0 otherwise, DJORDAN 1 if the bank is Jordanian, 0 otherwise,
PredLLPt predicted loan loss provisions at the end of the current period, PredALLt predicted
allowance for loan loss at the end of the current period, LLF log-likelihood function

second stage of the two-stage regressions presented in Table III. The ERN coefficient of
0.036 in the LLP equation is significant at the 5 percent level and supports the
proposition H2 that banks use LLPs to manage current earnings. The coefficient for
EQUt2 1 is insignificant in the LLP equation and positive and statistically significant at
the 5 percent level in the ALL equation. These results are consistent with those from
two-stage least squares using panel estimators and also contradict the capital
management H3. Results from both two-stage and three-stage approaches support
H1 and H2 and fail to support H3.
Table V presents potentially biased estimates of equations (5) and (6) using pooled
OLS instead of two-stage or three-stage least square estimators. The significance of the
likelihood ratio test for the diagonal variance-covariance matrix discussed above

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Table VI.
Tests of signaling
hypothesis

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116

Table VII.
Alternative tests of
signaling hypotheses

Independent variables
Intercept
ALLt2 1
LLPt2 1
INFLt2 1
TYPEt
GCC
TRADEDt
DJORDAN
R2
LLF

Dependent variable: CERNt

Parameters
t-statistics
0.004
0.335
20.205
0.001
0.007

0.18
2.58 * * *
2 2.33 * *
3.83 * * *
3.16 * * *

0.061
1,118.47

Dependent variable: NPLt

Parameters
t-statistics
0.052
0.335
1.027

5.95 * * *
8.24 * * *
4.28 * * *

2 0.016
2 0.021
0.035

2 2.12 * *
2 2.89 * * *
3.42 * * *
0.379
674.25

Notes: Significant at: *10, * *5 and * * *1 percent levels; n 451; based on pooled OLS regression that
test the impact of allowances and provisions on changes in future earnings (CERNt) and future (end-ofperiod) non-performing loans (NPLt); where: ALLt2 1 beginning of period allowance for loan losses/
beginning of period net loans, LLPt2 1 previous period loan loss provisions/end of previous period
net loans, NPLt end of period non-performing loans, CERNt percent change in earnings, INFLt
current period inflation rate, TYPEt 0 if the bank is conventional, 1 if Islamic, GCC 1 GCC bank
and 0 otherwise, TRADEDt 1 if the bank is publicly held and 0 otherwise, DJORDAN 1 if the bank is
Jordanian, 0 otherwise, LLF log-likelihood function

indicates that system methods are needed. However, it may be interesting to see
whether systems estimation gives results that are much different from single equation
OLS estimation.
First, note that ALL is included in the estimation of the LLP equation and that LLP
is included in the ALL equation as presented in Table V. Both coefficients are
significant in the respective equations at the 1 percent significance levels, as expected
based upon previous results from two-stage and three-stage least squares. Coefficients
for significant independent variables are of the same sign and similar magnitude
whether they are estimated by OLS in Table V or by systems methods, as presented in
Table IV. The only two exceptions are that the coefficient for INFL in the LLP equation
is statistically significant at the 5 percent level in Table IV and insignificant in Table V,
while the dummy variable for Egypt (DEGYPT) in the ALL equation is statistically
significant at the 5 percent level when estimated by three-stage least squares and
statistically insignificant when estimated by OLS. The coefficients are similar in
Tables IV and V and the only noticeable difference is that many of the t-statistics are
slightly higher in Table IV. While two or three-stage estimation is theoretically
preferred to OLS estimation, the implication of our work is that the basic conclusions
from previous single equation models are generally valid. Nevertheless, OLS
estimation may misstate the significance of some coefficients.
The signaling H4A and H4B are tested by two-stage estimation of equations (7)-(10),
which shows the relationship between changes in future earnings and LLP and ALL.
Equations (7)-(10) are similar to equations (1)-(4), except that lagged values of ALLt2 1
and LLPt2 1 replace the current period values of ALL and LLP and other independent
first-stage variables are appropriately lagged one period relative to equations (1) and (2).
Lagged values of equity to assets EQUt2 2 are included in first stage rather than the
second stage of estimation because we are not testing for capital management in this

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formulation of the model. The second stage involves estimating ALLt2 1 with predicted
lagged values of LLPt2 1 and changes in future earnings (CERN), as well as estimating
LLPt2 1 using predicted values of ALLt2 1 and CERN.
The positive signaling H4A suggests that the coefficients for CERN should be
positive in Panel B of Table VI, while the negative signaling H4B predicts that the
coefficients for CERN will be negative. The somewhat conflicting results in Panel B of
Table VI show that the coefficient for CERN is positive and significant at the 5 percent
level in the ALL equation suggesting that banks use allowances to signal higher future
earnings. In contrast, the negative coefficient for CERN in the LLP equation (significant
at the 10 percent level) supports the negative signaling H4B that increases in provisions
are negatively correlated with changes in future earnings either because provisions
reduce earnings or because they indicate problems with future nonperforming loans.
The signaling hypothesis is more commonly tested, as in previous papers, by noting
the relationship between current provisions and future earnings. The first column of
Table VII presents such results using a pooled OLS regression where the change
in earnings is the dependent variable. The statistically significant variables included in
previous equations are listed as the independent variables. The results are similar to
those presented in Table VI. The coefficient for ALLt2 1 is positive and significant at
the 1 percent level, whereas the coefficient for LLPt2 1 is negative and significant at the
1 percent level. Again, the positive signaling hypothesis is supported using allowances
and the negative signaling hypothesis is supported based upon LLPs. Although such
results appear contradictory, they need not be. Larger allowances mean greater future
earnings because a bank can afford to dip into the allowance account to smooth or
even increase future earnings. In the long-run, higher allowances mean higher future
earnings, while the negative relationship between provisions and future earnings may
be more of a short-term phenomenon. If a bank sets aside significant LLPs this year,
it either needs to replenish the ALL account, or it anticipates future loan losses
and has to increase LLP in the current period. Hence, if banks manage LLP for the
short-run and ALL for the long-run, then H4A, the positive signaling hypothesis is
supported when examining allowances and H4B the negative signaling hypothesis
is supported when examining provisions.
The second column of Table VII shows that the current period level of
non-performing loans (NPL) can be predicted fairly accurately from lagged values of
allowances and other independent variables. The results are consistent with the sign
predicted by H5. Thus, MENA banks allocate funds for allowances that reflect the
levels of current and future non-performing loans. This result supports Wall and
Kochs (2000) argument that banks establish allowance for doubtful loans in good
years to absorb losses in the future bad years.
7. Summary and conclusion
This study has examined the determinants of the ALL and LLPs using both a
two-stage approach and simultaneous equation system to address the potential
problem of estimation bias introduced by the estimating the ALL and LLP separately.
Our results imply that ALL and LLP are jointly determined and that MENA banks are
more likely follow a balance sheet approach to determining LLPs than an income
statement approach. We found that the potential bias and efficiency loss from single
equation OLS estimation was rather small meaning that general results from

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previous studies should be mostly valid. Nevertheless, since statistical significance of

coefficients varies among estimation techniques, we must recognize that the strength
of conclusions in some previous work has been affected by using OLS instead of two or
three-stage estimation procedures.
We have presented evidence that MENA banks engage in income smoothing, or
earnings management. However, our data fail to support the capital management
hypothesis probably because MENA banks have been historically well-capitalized
and have not needed to use allowances to meet Basel II capital requirements.
We provide support for both the positive and the negative signaling hypothesis. That
is, higher allowances probably mean higher earnings in the long-run (positive
signaling hypothesis), while higher provisions suggest lower future short-term
earnings (negative signaling hypothesis).
Our findings have policy implications as follows. First, when analysts assess the
quality of loans, they should estimate the LLPs and allowance jointly to more
accurately determine their effect on a banks income statement and balance sheet.
Second, since managers of Islamic and conventional banks treat loan loss accounts
similarly, they both appear to face similar incentives and motivations for earnings
management. Policy makers therefore do not need to differentiate between Islamic and
conventional banks when setting regulations to control income smoothing or earnings
manipulation. Finally, and perhaps the most noteworthy implication of our study, is
that stricter control over discretionary use of LLPs and allowances may reduce
earnings management and manipulation. Regulation in this area could prove beneficial
by providing investors with a more accurate representation of the financial positions of
both Islamic and conventional banks in the MENA region.
We acknowledge that the LLP account is only one of many accounts on the income
statement that could be used for signaling or to manage earnings, and that the ALL is
one of several accounts that could be used for signaling, earnings or capital
management. Thus, a potentially interesting avenue for future research would be to
examine other accruals (such as, unrealized gain/loss for trading securities) for their
role in managing earnings and capital. Regulators may also wish to explore whether it
is worthwhile to constrain other discretionary accounts to ensure that users of MENA
bank financial statements are presented with measures of earnings that are less subject
to management manipulation.
Notes
1. The countries in the MENA region for which we were able to collect adequate data from the
internet include the countries in the Gulf Cooperation Council (GCC) Bahrain, Kuwait,
Oman, Qatar, Saudi Arabia, and the United Arab Emirates, as well as for Egypt, Jordan, and
Lebanon. Internet data for banks in Morocco, Algeria, and Tunisia were not available for a
sufficient number of banks to be representative of the banking industries in those countries.
2. Prior research by Olson and Zoubi (2008) found significant differences between Islamic and
conventional banks and the TYPE dummy variable is used to control for such differences.
Similarly, the dummy variables for Egypt and Jordan are included because banks in these
two countries appear to have loan loss practices that are somewhat different from banks in
the GCC and Lebanon.
3. The loan to deposit ratio (which also measures a banks needs for additional capital) was not
significant as either a first or second-stage variable in the regression equations.

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4. Another source of bank capital is long-term debt. However, long-term bank debt is not as
prevalent in the MENA region as in other areas. Inclusion of a variable such as debt divided
by equity is highly co-linear with EQU and both cannot be estimated in the same model.
Inclusion of this variable instead of EQU provided lower predictive power than the preferred
model in equations (3) and (4) as evidenced by lower values of adjusted R 2 and the log of the
likelihood function.

Determinants of
loan loss and
allowances

5. Gross domestic product was not included in the final regression models because it was
subsumed by various dummy variables or the inflation variable.

119

6. A two-stage estimation approach with lagged ALL and lagged LLP, similar to equations (1)
and (2) in the first stage and with predicted values substituted into the equivalent of
equations (3) and (4) in the second stage produced similar, but slightly less significant results
than those presented in Table III. The Hausman test for strong exogeneity (based on lagged
variables) was also rejected at the 1 percent level.
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Corresponding author
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