The Hidden Message in AFS Securitites of US Banks

We examine US banks’ use of available-for-sale (AFS) securities to smooth their earnings during the most recent macroeconomic business cycle from 2001 to 2010. We contribute to the accounting literature by investigating the interaction between the macroeconomic environment and the income smoothing activities of US banks, and find four main results: First, our empirical results show evidence that US banks use AFS securities to smooth earnings. Second, we find that the realized gains and losses on AFS securities can predict the future core earnings of a bank, consistent with the signaling hypothesis of income smoothing (e.g. Barnea et al., 1975; Bartov, 1993). Third, we report evidence that US banks are more likely to smooth income when the general macroeconomic environment is favorable (good times) than when it is unfavorable (bad times). Fourth, our tests demonstrate that the signaling power of AFS securities for future core earnings tend to be higher during bad times than good times.