Discretion in bank loan loss allowance, risk taking, and earnings management

Abstract

We study whether bank managers’ use their discretion in estimating the allowance for loan losses (ALL) for efficiency or for opportunistic reasons. We do so by examining whether the use of this discretion relates to bank stability and bank risk taking, or whether it relates to earnings management to meet or beat earnings benchmarks. We find that banks that had higher abnormal ALL during the period prior to the 2007-2009 financial crisis engaged in less risk taking during the pre-crisis period and had a lower probability of failure during the crisis period. In tests related to earnings management to meet or beat earnings benchmarks, we find that abnormal ALL is unrelated to next period’s loss avoidance and just meeting or beating the prior year’s earnings. Our results suggest that bank managers use their discretion over ALL for efficiency and not for opportunistic purposes. They inform policy makers and accounting standard setters on banks’ use of accounting discretion as a means to build a cushion against future credit losses as they transition from the incurred loss model to the expected loss model for loan loss accounting.

Valuation Insight: Jin, Kanagaretnam, and Lobo study the allowance for loan losses by banks. Managers use discretion in determining loan loss allowances. More ‘abnormal’ allowances, rather than a signal that market values should decrease, preserve value by serving as a cushion against future shocks and, accordingly, decreased the probability of bank failures during the recent global financial crisis.