Ebook Accounting Discretion, Loan Loss Provisioning, and Discipline of Banks’ Risk-Taking
The recent financial crisis has energized politicians and regulators to scrutinize financial accounting standards as never before, creating significant pressure for change. For example, recent high profile proposals by Financial Stability Forum (2009) and U.S. Treasury (2009) call for standards setters to re-evaluate the incurred loss model underlying current loan loss provisioning requirements and consider a range of alternative approaches. A premise of these proposals is that loan loss accounting should adopt a more forward looking orientation that allows for recognition of future expected loan losses earlier in the credit cycle, which in turn would dampen pro-cyclical forces in periods of financial crisis. A key aspect of these alternatives is that, relative to the incurred loss model, they would generally increase the scope for judgment and discretion in determining loan loss provisions. However, as has long been recognized (e.g., Watts and Zimmerman (1986)), accounting discretion is a double-edged sword. On the one hand, increased discretion can facilitate incorporation of more information about future expected losses into loan provisioning decisions, but on the other hand it increases potential for opportunistic accounting behavior by bank managers, which may degrade the transparency of banks and lead to negative consequences.
The main objective of this paper is to empirically delineate significant economic consequences associated with observable differences in discretion permitted to banks under existing regulatory regimes. Exploiting significant cross-country variation in observed loan provisioning practices, we generate country-level measures of the discretion allowed to banks’ within a given country, where discretion is estimated relative to an incurred loss model. Using these country-level measures of observed discretion, we perform three fundamental analyses geared towards isolating implications of discretion for both the information properties of loan provisions and for bank transparency. First, we investigate the extent to which banks in countries allowing higher discretion use this enhanced flexibility to infuse loan provisioning practices with a more forward looking orientation relative to banks in lower discretion countries. Next, we investigate the possibility that discretion imposes costs on the banking system by impeding the ability of regulators and outside investors to monitor and discipline bank risk taking. We capture the extent of discipline over bank risk taking using two measures. First, we study the relation between discretion and the sensitivity of changes in bank capital to changes in the riskiness of a bank’s assets. Secondly, we examine the relation between discretion and the observed risk-shifting behavior of banks.
A fundamental role of financial reporting is to provide credible and relevant firm-specific information about the financial performance and condition of businesses. Such information is of central importance for governance of firms and to investors in their resource allocation decisions, as well as to regulators charged with prudential oversight of financial institutions. Loan loss provisioning is a key accounting choice that can significantly influence the information properties of banks’ financial reports with respect to reflecting changes in the fundamental risk attributes of the underlying loan portfolios. Current accounting procedures under both U.S. GAAP and IFRS utilize an incurred loss framework where a provision for loan losses is recognized only after loss impairment events have already occurred prior to the financial reporting date that are likely to result in non-payment of loans in the future. The focus is on reflecting losses expected to result from events during a given period, while limiting consideration of expected effects of future events.
An alternative to the incurred loss model posits that regulatory capital should operate as a buffer against unexpected losses (i.e., large, infrequent occurrences), while loan loss reserves should deal with expected losses ((Wall and Koch (2000), Basel Committee on Banking Supervision (1991)). This perspective underlies calls for loan loss accounting to fully incorporate all future expected losses regardless of whether a loss impairment event has occurred. Such proposals often introduce elements of earnings smoothing. In current deliberations, the FASB proposes adopting fair value accounting for loans (FASB (2009), while the IASB favors an expected loss approach where expectations of future losses over the life of a loan are incorporated ex ante into effective interest rates (IASB (2009). While differing in the details, such proposed regimes generally allow greater discretion to incorporate a broader range of available credit information and create an expanded role for managerial judgment in assessing future expected losses.
But as noted earlier, there are important trade-offs associated with increased discretion, and any benefits must be weighed against the costs of increased opportunism by managers. To investigate the economic consequences associated with discretion, we use a large sample of banks from 23 countries to estimate two measures of observed discretion allowed to banks within a given country under the existing regulatory regime. The first is a smoothing measure defined as the coefficient on earnings in a regression of loan loss provisions on a vector of non discretionary provisioning determinates and earnings. A higher coefficient is posited to reflect more discretion to deviate from the incurred loss model and smooth via the loan loss provision. The second measure is the incremental explanatory power achieved by adding earnings to a regression of loan loss provisions on a vector of non-discretionary determinants, where a higher incremental explanatory power is posited to capture higher levels of discretion.
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