Did the SEC Impact Banks’ Loan Loss Reserve Policies and Their Informativeness?

Abstract:     
During the late 1990’s, the SEC became concerned with banks’ overstating their loan loss reserves to manage reported income and issued guidance on loan loss estimation to discourage such behavior. We present evidence that banks changed their loan loss allowance estimation methods in response to the SEC’s regulatory guidance and these changes significantly impacted the informativeness of the allowances, both in explaining future losses and conveying information to the market. While the informativeness improved for strong banks, it declined for the weak banks. The divergent effects for strong and weak banks can be explained by differences in the stability of banks’ business environments and differences in earnings management incentives. Our results help to explain why some (weak) banks delayed loss recognition during the recent financial crisis — a factor that has been recognized as contributing to pro-cyclicality of lending policies that, in turn, amplified the severity of the financial crisis.

Number of Pages in PDF File: 48

Keywords: Loan Loss Allowances, Provisions, Bank Accounting, Smoothing, SEC, Regulatory Intervention

JEL Classification: G14, G21, M41

working papers series