The Implications of Credit Risk Modeling for Banks' Loan Loss Provision Timeliness and Loan Origination Procyclicality

Abstract:     
We identify two credit risk modeling (CRM) activities from disclosures in banks’ 1995-2009 financial reports: (1) statistical analysis of underwriting criteria, loan performance statuses, and relevant economic variables (MODEL); and (2) stress testing of credit losses to possible adverse future events (STRESS). We expect MODEL to discipline banks’ loan loss reserving during stable economic times and for homogeneous loans, but to be limited at sharp turns in economic cycles and for heterogeneous loans, when STRESS is essential. We predict and find that MODEL (STRESS) is associated with timelier LLPs on average across our sample period and late (early) in the financial crisis.

We expect CRM to enhance LLP timeliness by yielding informationally richer LLPs that depend less on summary underwriting criteria. We predict and find that banks engaging in MODEL record LLPs that are less positively (more strongly) associated with the loan-to-income ratios for their residential mortgages (their current loan performance and relevant economic variables).

We predict and find that banks engaging in MODEL exhibit less procyclical loan originations, particularly for homogeneous loans. We predict that banks engaging in STRESS exhibit less procyclical originations of heterogeneous loans, and find that this is the case during recessions.

Number of Pages in PDF File: 76

Keywords: credit risk modeling, loan loss provisions, timeliness, procyclicality, financial crisis, disclosure

JEL Classification: G21, G28, M41, M48

working papers series