Policy Uncertainty and Loan Loss Provisions in the Banking Industry

Abstract

Policy uncertainty (PU) is an increasingly important issue in many economies. Extensive evidence indicates that higher PU is associated with future negative macroeconomic and microeconomic conditions. In this paper, we examine how PU affects banks’ accruals for loan losses. Consistent with banks signaling more expected loan losses, we document that in times of higher PU, banks make more loan loss provisions. This positive association is more pronounced for banks that were previously less prudent in their risk-taking and loan loss reserving, indicating that less prudent banks are more adversely affected by loan losses in difficult times. We also show that higher attention paid to a banks’ financial reporting strengthens the role of loan loss provisions as a signal of expected loan losses. Overall, our paper offers insight into how, in the face of PU, banks convey information about their loan portfolios to their stakeholders.

Keywords: Policy Uncertainty; Accrual Estimates; Banking; Loan Loss Provisions; Earnings Management

JEL Classification: G21; M41; G32