Essays on the Loan Loss Provisions in the Banking Industry

Abstract

This dissertation consists of three related but independent essays on the accounting for loan loss provisions (LLP) in the banking industry. While LLP is the largest accrual item on banks balance sheets, little is known about accounting for LLP. The first and the second essays investigate how the equity market prices LLP of US banks in the post-Basel period. The third essay examines how International Financing Reporting Standards (IFRS) affect loan loss provisioning of European banks, and its economic consequences. Below, I briefly elaborate on the three essays. The first essay examines the value relevance of LLP. Prior studies find that banks' discretionary LLP (DLLP) are perceived positively by the market and attribute this to greater LLP signaling to investors the soundness of the bank. However, these studies are based on data from the pre-Basel era when LLP increased Tier 1 capital and thus had positive implications. I focus on the post-Basel period in which LLP does not affect Tier 1 capital and apply a better specified model to test for the value relevance of loan loss provisions. I find that DLLP is not value relevant in the post-Basel period. This result is consistent throughout the recent financial crisis, which is contrary to Ryans (2011) conjecture that DLLP may be valued positively during economic downturn. In addition, LLP and non-discretionary LLP (NLLP) are perceived negatively by the market. I also show that findings in the long-window value relevance test still hold in the short-window market reaction test. Overall, in the post-Basel period, DLLP provides no value relevant information whereas NLLP conveys value relevant information incremental to earnings. The second essay documents evidence on the mispricing of banks LLP in the equity market. First, I find that equity investors do not correctly price information in LLP: the level of LLP (change in LLP) is strongly (weakly) negatively related to one-year ahead future returns. When LLP is decomposed into non-discretionary LLP (NLLP) and discretionary accruals (DLLP), the level of and change in NLLP appears to be the main driver of return predictability. Second, I show that analysts do not fully impound information in LLP into their one year-ahead earnings forecasts: the level of and change in LLP are negatively related to analyst forecast optimism. Decomposition of LLP suggests that such bias is mainly due to NLLP. In sum, my findings suggest that equity market participants do not fully appreciate the loan-related risk information in LLP. The third essay examines the effect of IFRS on LLP of European banks and their loan origination pro-cyclicality. Using 1,545 bank-year observations in 14 European countries during 1996 to 2009, I find that, contrary to prior studies, there is weak evidence that banks reduce earnings smoothing via LLP in the post-IFRS period. However, there is evidence that banks increase LLP timeliness in the post-IFRS period. In particular, the decrease in earnings smoothing is pronounced for low-capitalized banks, whereas the increase in LLP timeliness is more pronounced for high-capitalized banks. My finding raises the possibility that the prior studies are subject to misspecification by omitting LLP timeliness. Next, I find that IFRS adoption does not on average exacerbate the pro-cyclical relationship between LLP and loan growth with the exception of small banks. These findings are robust to various settings. My evidence suggests that loan loss provisioning under IFRS does not threaten the stability of the financial system.