The Politics of Underreporting Loan Losses: Evidence from the Mandatory Shift to Expected Credit Loss Provisioning in China

Abstract

We study how political considerations affect banks’ loan loss provisions using China’s mandatory shift to expected credit loss (ECL) provisioning. We find that the mandatory shift has no overall net effect on the magnitudes or timeliness of provisions for state-owned banks. While these properties of provisions increase among state-owned banks with relatively weak political influence, these increases diminish among other state-owned banks (i.e., banks that have local officials with strong career incentives; serve as a key instrument in providing credit subsidies; and hold strong connections with asset management companies). Further, nonstate banks increase the magnitudes and timeliness of provisions following the mandatory shift, suggesting that strong regulatory monitoring can lead to faithful implementation of ECL provisioning in emerging economies. Overall, our findings support the political view of state ownership that politicians underreport loan losses to extract private benefits, thereby reducing the effectiveness of ECL adoption.