Bank Loan Loss Provisions: A Reexamination of Capital Management, Earnings Management and Signaling Effects

Abstract

This study documents evidence on the choice of loan loss provisions by bank managers. In particular, we reexamine three hypotheses investigated by prior studies. First, we examine whether the 1990 change in capital adequacy regulations affects the relation between capital and loan loss provisions. We find that the relation is less negative in the new regime consistent with a reduction in incentives to manage regulatory capital via loan loss provisions in the post 1990 capital regime.

Second, we find that there is no significant relation between earnings (before loan loss provisions) and loan loss provisions even in the new regime when the cost of smoothing via loan loss provisions is expected to be lower than in the old regime.

Third, we reexamine the signaling hypothesis which implies a positive relation between loan loss provisions and future earnings changes. We find, contrary to the signaling hypothesis, that there is a negative relation between loan loss provisions and one-year ahead change in earnings. We also investigate whether bank stock returns are positively related to discretionary loan loss provisions as implied by the signaling hypothesis. We find that stock returns are negatively related to discretionary loan loss provisions. We conclude that evidence consistent with signaling documented in prior studies is likely to be specific to the period examined in those studies.

Note: This is a description and not the actual abstract.

JEL Classification: C23, G14, G36, M41