The Expected Rate of Credit Losses on Banks' Loan Portfolios
Posted: 12 Feb 2015 Last revised: 18 Dec 2017
Date Written: March 2017
Estimating expected credit losses on banks’ portfolios has long been difficult. The issue has become of increasing interest to academics and regulators, as the FASB and IASB consider new regulations for impairment of loans. This study develops a measure of the one-year-ahead expected rate of credit losses (ExpectedRCL) that combines various measures of credit risk disclosed by banks. It uses cross-sectional analyses to obtain coefficients needed to estimate each period’s measure of expected credit losses. ExpectedRCL performs substantially better than net charge-offs in predicting one-year-ahead realized credit losses and reflects nearly all the credit loss-related information in the charge-offs. ExpectedRCL also contains incremental information about one-year-ahead realized credit losses relative to the allowance and provision for loan losses and the fair value of loans. Further, ExpectedRCL is a more accurate predictor of the provision for loan losses than analyst provision forecasts and it is incrementally useful beyond other credit risk metrics in predicting bank failure up to one year ahead.
Keywords: Banks, credit losses, loans, loan loss provisions, standard setting, bank failure, earnings surprise
JEL Classification: G18, G21, M41
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