The Implications of Credit Risk Modeling for Banks' Loan Loss Provision Timeliness and Loan Origination Procyclicality

89 Pages Posted: 2 Jan 2012 Last revised: 9 Jan 2014

Gauri Bhat

Southern Methodist University (SMU)

Stephen G. Ryan

New York University (NYU) - Leonard N. Stern School of Business

Dushyantkumar Vyas

University of Toronto - Rotman School of Management; University of Toronto at Mississauga

Date Written: December 20, 2013

Abstract

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.

Keywords: credit risk modeling, loan loss provisions, timeliness, procyclicality, financial crisis, disclosure

JEL Classification: G21, G28, M41, M48

Suggested Citation

Bhat, Gauri and Ryan, Stephen G. and Vyas, Dushyantkumar, The Implications of Credit Risk Modeling for Banks' Loan Loss Provision Timeliness and Loan Origination Procyclicality (December 20, 2013). Available at SSRN: https://ssrn.com/abstract=1978409 or http://dx.doi.org/10.2139/ssrn.1978409

Gauri Bhat

Southern Methodist University (SMU) ( email )

6212 Bishop Blvd.
Dallas, TX 75275
United States
214-7682964 (Phone)

Stephen G. Ryan (Contact Author)

New York University (NYU) - Leonard N. Stern School of Business ( email )

44 West 4th Street, Suite 10-73
New York, NY 10012-1118
United States
212-998-0020 (Phone)

Dushyantkumar Vyas

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6
Canada

University of Toronto at Mississauga ( email )

3359 Mississauga Rd N.
Mississauga, Ontario L5L 1C6
Canada

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