The Impact of the 1989 Change in Bank Capital Standards on Loan Loss Provisions

Abstract:     
This paper examines the effect of a regulation change on management incentives and accrual estimates. We investigate whether managers of banks with low capital ratios reduce their banks' loan loss provisions after the 1989 change in capital standards. The loan loss provision increases the capital ratio prior to 1989 and decreases it after 1989. In examining our hypothesis we control for 1) gross loans non- performing loans and write-offs 2) earnings management incentives and 3) interest rates. The results show that managers of banks with low capital ratios reduced their loan loss provisions during the 1990-1992 period compared to the 1985-1988 period. Banks with high capital ratios exhibited insignificant differences between these two periods. The managing behavior of loan loss provisions has implications for regulators auditors investors and other users of the financial statements as they evaluate the financial statements of banks.

JEL Classification: G28, M41

working papers series