Do Loan Loss Reserves Behave like Capital? Evidence from Recent Bank Failures

61 Pages Posted: 22 Jul 2010 Last revised: 15 Feb 2014

See all articles by Jeffrey Ng

Jeffrey Ng

Hong Kong Polytechnic University - School of Accounting and Finance

Sugata Roychowdhury

Boston College

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Date Written: January 9, 2014

Abstract

Regulatory capital guidelines allow for loan loss reserves to be added back as capital. The evidence in this paper suggests that the influence of loan loss reserves added back as regulatory capital (hereafter referred to as “add-backs”) on bank risk cannot be explained by either economic principles underlying the notion of capital, or accounting principles underlying the recording of reserves. Specifically, we observe that in sharp contrast to the economic notion of capital as a buffer against bank failure risk, add-backs are positively associated with the risk of bank failure during the recent economic crisis. Further the positive association of add-backs with bank failure risk is concentrated among cases in which the add-backs are highly likely to increase a bank’s total regulatory capital. The evidence cannot thus be fully explained by accounting principles either, since the role of loan loss reserves according to those principles does not depend on whether the reserves generate a regulatory capital increase. Additional analysis suggests that the observed influence of loan loss reserves on bank failure risk may be an unintended consequence of their regulatory treatment as capital.

Keywords: Bank Failure, Bank Risk, Regulatory Capital, Capital Adequacy, Loan Loss Reserves, Loan Loss Provisions, Loan Charge-Offs

JEL Classification: G21, G28, G32, G38, M41, M48

Suggested Citation

Ng, Jeffrey and Roychowdhury, Sugata, Do Loan Loss Reserves Behave like Capital? Evidence from Recent Bank Failures (January 9, 2014). Available at SSRN: https://ssrn.com/abstract=1646928 or http://dx.doi.org/10.2139/ssrn.1646928

Jeffrey Ng

Hong Kong Polytechnic University - School of Accounting and Finance ( email )

Hung Hom
Kowloon
Hong Kong

Sugata Roychowdhury (Contact Author)

Boston College ( email )

140 Commonwealth Avenue
Chestnut Hill, MA 02467
United States
617-552-1764 (Phone)

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