The Expected Rate of Credit Losses on Banks' Loan Portfolios

Abstract

This study develops a timely and unbiased measure of expected credit losses. The expected rate of credit losses (ExpectedRCL) is a linear combination of various non-discretionary credit risk-related measures disclosed by banks. ExpectedRCL performs substantially better than net charge-offs, realized credit losses, and fair value of loans in predicting credit losses, and reflects all the explanatory power of the credit loss-related information in these variables. It may therefore serve as a benchmark for estimating the profitability of a loan yield when evaluating bank performance and value creation. Although banks have been disclosing fair value estimates for their loan portfolios since 1992, these estimates appear to perform relatively poorly in capturing expected credit losses. Investors also appear to not fully incorporate the expected credit losses in pricing bank stocks, as ExpectedRCL is negatively and significantly related to subsequent stock returns. ExpectedRCL also contains incremental information about future credit losses relative to the allowance and provision for loan and lease losses (ALLL and PLLL, respectively). While these discretionary measures of credit losses contain incremental information to ExpectedRCL, unlike ExpectedRCL they are not mispriced by investors, and they are less significant than ExpectedRCL in predicting future credit losses. The evidence provided by this study is also relevant for policy deliberation as standard setters contemplate revising existing rules relating to loss provisioning and requiring the recognition of some expected credit losses.

Keywords: Credit Losses, Bank Performance, Standard Setting

JEL Classification: G14, G21, M41