Are Interest Rate Swaps Used to Manage Banks’ Earnings?

Previous research has shown that loan loss provisions and security gains and losses are used to manage banks’ net income. However, these income components are reported below banks largest operating component, net interest income (NII). This study extends the literature by examining whether banks exploit the accounting permitted under past and current hedge accounting standards to manage NII by entering into interest rate swaps. Specifically, I investigate whether banks enter into receive-fixed/pay-variable swaps to increase earnings when unmanaged NII is below management’s target for NII. In addition, I investigate whether banks enter into receive-variable/pay-fixed swaps to decrease earnings when unmanaged NII is above management’s target for NII. Swaps-based earnings management is possible because past and current hedge accounting standards allow receive-fixed/pay-variable swaps (receivevariable/pay-fixed) to have known positive (negative) income effects in the first period of the swap contract. However, entering into swaps for NII management is not costless, because such swaps change the interest rate risk position throughout the swap period. Thus, I also examine whether banks find it cost-beneficial to enter into offsetting swap positions in the next period to mitigate interest rate risk caused by entering into earnings management swaps in the current period. Using 546 bank-year observations from 1995 to 2002, I find that swaps are used to manage NII. However, I do not find evidence that banks immediately enter into offsetting swap positions in the next period. In sum, this research demonstrates that banks exploit the accounting provided under past and current hedge accounting rules to manage NII. This NII management opportunity will disappear if the FASB implements full fair value accounting for financial instruments, as foreshadowed by FAS No. 133.