The Relevance of Discretionary Loan Loss Provisions During the Financial Crisis

Banks’ use of accounting discretion in estimating loan loss provisions (LLPs) during the financial crisis has come under severe criticism. We argue, however, that it is during periods of instability like the financial crisis that accounting discretion is most relevant. We find that the discretionary component of LLPs exhibits dramatically stronger associations with contemporaneous stock returns and with subsequent realized loan losses during the crisis than in surrounding periods. We also find that discretionary LLPs are associated with the Treasury’s allocation of TARP funds. Tests surrounding the TARP funding shock provided added validity to our empirical specifications. The significant beneficial role of discretion in LLPs during the financial crisis is especially important in light of the FASB’s new accounting rules that are likely to alter the level of accounting discretion underlying these estimates.

Keywords: Financial Crisis; Banks; TARP; Loan Loss Provisions; Accounting Discretion; Value Relevance

JEL Classification: G01; G21; G28; M41

Suggested Citation: Suggested Citation

Beck, Paul J. and Chen, Zhenhua and Li, Bin and Narayanamoorthy, Ganapathi S., The Relevance of Discretionary Loan Loss Provisions During the Financial Crisis (May 20, 2019). Available at SSRN: https://ssrn.com/abstract=2835606 or http://dx.doi.org/10.2139/ssrn.2835606