Portuguese financial institutions largely skirted the consequences of the 2007–2008 meltdown in the markets for asset-backed securities, collateralized debt obligations, asset-backed commercial paper, etc. A possible reason was counter-cyclical provisioning, under which, in addition to provisions for loan losses on loans currently outstanding, Portuguese banks recorded additional provisions when their loan portfolios were growing strongly, drawing on them to reduce loan loss provisions during periods of lending contraction. The idea behind counter-cyclical provisioning is that over the course of a business cycle, the loan loss overprovisions early in the cycle will be balanced out by under-provisions later on, with no net effect on total earnings over the cycle. Thus, when financial instruments markets experienced a liquidity crunch and lending contracted in 2007–2008, Portuguese banks did not need to make as large provisions for losses as many other banks, since some of these losses were absorbed by overprovisions in earlier boom years. As a result, Portuguese banks did not run into capital adequacy shortfalls to the same extent as banks in other countries.

Counter-cyclical provisioning is a form of earnings management, in which loan losses are smoothed over the course of a business cycle. This practice is contrary to IFRS 9, under which financial asset write-downs are based only on balances outstanding as at the financial statement date.

Required

a.         Assess the relevance and reliability of counter-cyclical provisioning.

b.         Does counter-cyclical provisioning constitute good or bad earnings management? Explain.

c.         Assuming that manager compensation is based on both net income after counter-cyclical provisioning and share price performance, how do you think bank management would react to an accounting standard requiring counter-cyclical provisioning?