Do loan loss reserves behave like capital? Evidence from recent bank failures

By Jeffrey Ng, S. Roychowdhury. Review of accounting studies, 2014

152 citations recorded by the source corpus.

Regulatory capital guidelines allow for loan loss reserves to be added back as capital. Our evidence suggests that the influence of loan loss reserves added back as regulatory capital (hereafter referred to as “add-backs”) on bank risk cannot be explained by either economic principles underlying the notion of capital or accounting principles underlying the recording of reserves. Specifically, we observe that, in sharp contrast to the economic notion of capital as a buffer against bank failure risk, add-backs are positively associated with the risk of bank failure during the recent economic crisis. Furthermore, the positive association of add-backs with bank failure risk is concentrated among cases in which the add-backs are highly likely to increase a bank’s total regulatory capital. The evidence cannot thus be fully explained by accounting principles either, since the role of loan loss reserves according to those principles does not depend on whether the reserves generate a regulatory capital increase. Additional analysis suggests that the observed influence of loan loss reserves on bank failure risk may be an unintended consequence of their regulatory treatment as capital.

Subfields: Accounting, Finance

View Paper: https://www.semanticscholar.org/paper/3aa386feb8cce33122992ffdd79407af1626c7b1

How researchers see this paper

The researchers whose trusted networks rank it highest, strongest advocate first. Every researcher gets a different order.

In Accounting

1. D. Curcio
2. Björn Imbierowicz
3. Christian Rauch
4. Iftekhar Hasan
5. Allen N. Berger
6. Peterson K. Ozili

In Finance

1. D. Curcio
2. Björn Imbierowicz
3. Christian Rauch
4. Iftekhar Hasan
5. Allen N. Berger
6. Peterson K. Ozili

Citations in the corpus

• Earnings and capital management and signaling: the use of loan-loss provisions by European banks (2015, background): “Recent research by Ng and Roychowdhury (2011) investigates the relationship between loan-loss reserves added back as regulatory capital and the risk of bank failure.”
• The Relationship between Liquidity Risk and Credit Risk in Banks (2014, methodology): “Aubuchon and Wheelock (2010), Ng and Roychowdhury (2011), Cole and White (2012), Berger and Bouwman (2013), and DeYoung and Torna (2013) are especially relevant to our work because they focus on bank defaults during the recent financial crisis.”
• Policy uncertainty and loan loss provisions in the banking industry (2020, unknown): “Conversely, customer concentration increases industrial companies’ risk and cost of capital (Dhaliwal et al., 2016; Campello and Gao, 2017), while loan type concentration increases the probability of bank failure (Ng and Roychowdhury, 2014).”
• Market pricing of banks’ fair value assets reported under SFAS 157 since the 2008 financial crisis (2015, unknown): “The crisis was also notable for its impact on the banking industry (e.g., Akins et al., 2004; Krishnan and Zhang, 2014; Ng and Roychowdhury, 2014).”
• The impact of bank capital, bank liquidity and credit risk on profitability in postcrisis period:‎ A comparative study of US and Asia (2019, unknown): “Significantly, the condition imposed by regulators to hold a higher amount of equity capital is found to enhance risk absorption capacity of banks in earlier studies such as Aggarwal and Jacques (2001) and in recent studies such as Ng and Roychowdhury (2014).”
• The effect of credit risk, liquidity risk and bank capital on bank profitability: Evidence from an emerging market (2020, unknown): “Hence why, after the financial crisis, risk management in the majority of banks around the world is mostly focused on credit risk (Chou & Buchdadi, 2016; Ezike & Oke, 2013; Lassoued et al., 2016; Leung et al., 2015; Ng & Roychowdhury, 2014).”