The balance sheets of Japanese banks in the late 1990s were damaged by the enormous amount of non-performing loans (NPLs) that had accumulated over the previous decade. NPLs at the end of fiscal year for 1997 (March 1998) reached 30 trillion yen, or 5.5 percent of loans supplied by domestically licensed banks. 1 The write off of NPLs against equity leading to a sharp fall in the ratio of equity capital to assets (the book based capital to asset ratio) of domestically licensed banks in March 1998 was followed by a long lasting fall in the domestic lending growth (Figure 1). Domestic loans fell by 20 trillion yen, or about 4 percent during the three year period from April 1997 to March 2000. The BOJ’s tankan “lending attitude of financial institutions” diffusion indices also experienced sharp declines in March 1998.
Did this fall in bank capital, the “capital crunch”, cause the reduction in supply of bank loans, the “credit crunch” in the late 1990s? In order to satisfy the capital adequacy requirements, banks may have cut back on their lending in response to large losses of capital as issuing the new equity incurs costs associated with asymmetric information between investors and banks. When a banking system involves binding capital requirements, in addition to the standard reserve requirements, it will be possible that the limitation on the expansion of loans may be capital and not reserves.
The allowance for loan and lease losses, which was originally referred to as the “reserve for bad debts,” is a valuation reserve established and maintained by charges against the bank’s operating income. As a valuation reserve, it is an estimate of uncollectible amounts that is used to reduce the book value of loans and leases to the amount that is expected to be collected.
Few banks provided reserves for bad debts until the Internal Revenue Service (IRS) allowed the additions to such reserves to be deducted on a bank’s tax return. Although such deductions have been allowed since the passage of the Revenue Act of 1921, no clear-cut guidelines for the amount to be deducted were established until 1965, when the IRS issued Revenue Ruling 65-92. Under this ruling, a bank could make tax-deductible additions to its loan loss reserve until the reserve totaled 2.4 percent of eligible outstanding loans (as defined).
The objective of this paper is twofold. First, we investigate the relation between earnings quality and segment disclosure. Second, we analyze whether firms providing higher quality of segment information enjoy a lower cost of capital. For the analysis of the relation between earnings quality and segment disclosure we create an index of quantity of voluntary segment disclosure. We use the residuals of a regression of quantity of segment information on the determinants of segment disclosure as a proxy for the quality of segment disclosure. We argue that quality (and not quantity) of segment disclosure will have an impact on cost of capital.
We expect that earnings quality and segment disclosure will be related in a predictable way. The literature on information economics suggests that firms provide information to decrease information asymmetries (Grossman and Hart, 1980; Milgrom, 1981; Verrecchia, 1983). This provision of information could be achieved through several channels, including the reported accounting numbers and through additional disclosure. Verrecchia (1990) and Penno (1997) directly model the relation between earnings quality and disclosure, showing that more expansive disclosure is expected in firms with better earnings quality. However, results in the empirical literature are mixed, probably due to the use of empirical measures of disclosure that include information expected to be useful for investors (that disaggregates, explains or complements the reported numbers) and information that is difficult to verify and that might not be useful for investors.
