The Implications of Credit Risk Modeling for Banks' Loan Loss Provision Timeliness and Loan Origination Procyclicality
Southern Methodist University (SMU)
Stephen G. Ryan
New York University (NYU) - Leonard N. Stern School of Business
University of Toronto - Rotman School of Management; University of Toronto at Mississauga
December 20, 2013
We identify two credit risk modeling (CRM) activities from disclosures in banks’ 1995-2009 financial reports: (1) statistical analysis of historical data on 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 origination and loan loss provisions (LLPs) for homogeneous loans during stable economic times, but to be limited for heterogeneous loans and for all loans during sharp economic downturns, when STRESS is essential. We predict and find that banks engaging in MODEL exhibit timelier LLPs during stable economic times, particularly for homogeneous loans, and also late in the financial crisis after data on elevated credit losses had accumulated, but not early in the financial crisis. We further predict and find that these banks exhibit less procyclical loan originations, particularly for homogeneous loans. We predict and find that banks engaging in STRESS exhibit timelier LLPs for both homogeneous and heterogeneous loans during recessions, including early in the financial crisis. We further predict and find that these banks exhibit less procyclical loan originations for both loan types during recessions.
Number of Pages in PDF File: 89
Keywords: credit risk modeling, loan loss provisions, timeliness, procyclicality, financial crisis, disclosure
JEL Classification: G21, G28, M41, M48
Date posted: January 2, 2012 ; Last revised: January 9, 2014
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