Expected Loan Loss Provisioning: An Empirical Model

49 Pages Posted: 1 Mar 2019 Last revised: 7 Mar 2019

See all articles by Yao Lu

Yao Lu

University of Chicago - Booth School of Business

Valeri V. Nikolaev

University of Chicago Booth School of Business

Date Written: February 28, 2019

Abstract

Recently introduced accounting standards require that financial institutions provision for expected losses on their loan portfolios. Understanding the economic consequences of provisioning for expected losses is of significant interest to academics and regulators. We develop an empirical model of expected loan loss provisioning and use it to construct a bank-year measure of under-provisioning for expected losses. The model relies on forward-looking bank- and macro-economic indicators of future losses. The estimated expected losses are substantially more informative in explaining realized losses as compared to the reported numbers. Unlike the reported provisions, the estimated provisions for expected losses behave in a counter-cyclical fashion. Using our measure of under-provisioning, we find evidence consistent with under-provisioning for expected losses distorting banks’ lending, financing, and dividend decisions. While in practice banks need not provision in the way predicted by the model, we provide a useful benchmark to evaluate provisioning under the new accounting rules.

Keywords: expected loss model, loan loss provisioning, under-provisioning, bank decisions

JEL Classification: G21, M40, M41

Suggested Citation

Lu, Yao and Nikolaev, Valeri V., Expected Loan Loss Provisioning: An Empirical Model (February 28, 2019). Chicago Booth Research Paper No. 19-11. Available at SSRN: https://ssrn.com/abstract=3344657 or http://dx.doi.org/10.2139/ssrn.3344657

Yao Lu

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

Valeri V. Nikolaev (Contact Author)

University of Chicago Booth School of Business ( email )

5807 South Woodlawn Avenue
Chicago, IL 60637
United States

HOME PAGE: http://faculty.chicagobooth.edu/valeri.nikolaev/index.html

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