Do Changes in the Timeliness of Loan Loss Recognition Affect Bank Risk Taking?

Abstract:     
Risk taking is the core of banks’ business and there is a clear intertemporal relationship between bank lending and loan losses. Therefore, banks are subject to various rules and regulations on risk measurement, risk reporting, and risk provisioning. In this paper we investigate the link between the timeliness of loan loss recognition and bank risk taking behavior. We take advantage of a natural experiment - the compulsory introduction of dynamic loan loss provisioning in the Spanish banking system in 2000 - to study changes in bank risk taking and the influence of bank governance after an exogenous change in bank accounting rules. Based on a large and representative matched bank-firm dataset we apply a difference-in-difference methodology to measure banks’ changes in the timeliness of loss recognition and risk taking between the pre- and post-adoption period. Our findings suggest that a) the timeliness of loan loss recognition increased after the new dynamic provisioning system became effective, and b) the banks’ appetite for risk subsequently decreased. A further analysis shows that the effects of the new accounting standard were stronger for banks with weaker governance (i.e. caja banks). Our study makes several contributions to the accounting, banking and finance literature and has implications for policy makers, accounting standard setters, and bank regulators.

Number of Pages in PDF File: 28

Keywords: banks, loan loss provisions, accounting conservatism, bank regulation, bank governance

JEL Classification: G21

working papers series