The SEC and Banks’ Loan Loss Reserve Policies

The following post comes to us from Paul Beck and Ganapathi Narayanamoorthy, both of the Department of Accountancy at the University of Illinois at Urbana-Champaign.

In our paper, Did the SEC Impact Banks’ Loan Loss Reserve Policies and Their Informativeness?, which was recently made publicly available on SSRN, we study the joint impact of the SEC’s intervention in bank regulation during the late 1990’s and earnings management. In contrast with traditional bank regulators who focused on understatement (adequacy) of banks’ loan loss reserves, the SEC was concerned with overstatement of loan loss reserves to manage reported income. The SEC’s intervention in banking regulation involved several initiatives. These included investigations of banks that were alleged to have overstated loan loss allowances, the issuance of loan loss guidance in Staff Accounting Bulletin (SAB) 102, and pressuring traditional bank regulators belonging to the Federal Financial Institutions Examination Council (FFIEC 2001) to issue a policy statement affirming SAB 102 guidance. The SAB 102 loan loss guidance requires bank holding companies to use a consistent methodology that can be justified vis-à-vis actual loan loss (charge-off) rates and also imposes responsibility on bank examiners and financial statement auditors to evaluate controls over the loan loss estimation process.

Although the SAB 102 guidance was designed to discourage banks in “strong” financial condition from overstating loan loss allowances in order to smooth income, it does not discourage understatements of loan loss allowances by “weak” banks. By demonstrating consistency with historical charge-off rates, banks can delay making increases to their loan loss allowances/provisions in response to deteriorating conditions. Thus, we contend that SAB 102 guidance can create opportunities for “weak” banks to obtain regulatory slack by pushing back against traditional bank regulators who might question the adequacy of their loan loss allowances.

To analyze the joint impact of the SEC’s regulatory intervention and earnings management incentives (driven by economic conditions) on banks’ loan loss allowances/provisions, we perform two association tests between loan loss allowances and risk indicators. Our first test looks backward at the association between current loan loss allowances and past charge-offs to provide evidence about how the SEC’s regulatory intervention impacted the methodologies used by banks in setting their loan loss allowances. The second association test evaluates the effect of the SEC’s intervention on the ability of loan loss provisions/allowances to explain future charge-offs, cash flows, and short-window security returns.

We find that, during the early and mid-1990’s (prior to the SEC’s regulatory intervention), banks’ loan loss provisions/allowances were more highly associated with non-performing loans than with past charge-offs. However, consistent with SAB 102’s guidance, we find that banks’ loan loss allowances became more (less) associated with past charge-offs (non-performing) loans in periods after the SEC’s intervention. In accord with the SEC’s targeting banks with overstated loan allowances, we find that the associations between loan loss allowances and both past and future charge-offs strengthened for “strong” banks. In contrast, the loan loss allowances of “weak” banks did not exhibit higher associations with future charge-offs after SAB 102 guidance became effective. Rather, the association was particularly low in the period just prior to the financial crisis. Thus, while the FFIEC’s 2001 Policy Statement was intended to promote greater consistency in regulatory guidance and in banks’ loan loss policies, we actually find contrary evidence of greater cross-sectional variation in the ability of banks’ loan loss allowances to explain future losses after regulatory intervention.

The earnings-future cash flows associations parallel the associations between loan loss allowances and charge-offs. After SAB 102, the earnings of strong banks better explain future cash flows than before, while the earnings of weak banks had diminished ability to do the same. Finally, unexpected loan loss provisions have higher associations with short-window stock returns for strong banks after the SEC’s intervention, while the associations for the weak banks declined. Overall, the results suggest that the informativeness to the market improved for strong banks, but not for weak banks.

The full paper is available for download here.

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