Accounting Discretion, Loan Loss Provisioning and Discipline of Banks’ Risk-Taking

In our paper, Accounting Discretion, Loan Loss Provisioning and Discipline of Banks’ Risk-Taking, forthcoming in the Journal of Accounting and Economics, we empirically delineate economic consequences associated with differences in accounting discretion permitted to banks under existing regulatory regimes. Policy makers argue that loan loss accounting should allow bank managers’ more discretion to incorporate forward-looking judgments into loan loss provisions. This paper explores potential consequences of such increased discretion for the role of accounting information in supporting outside discipline of bank risk-taking.

Using a large sample of banks from 27 countries, we estimate two distinct constructs of the extent to which discretionary loan provisioning practices within a country reflect a forward-looking orientation. We investigate whether each aspect is associated with stronger or weaker discipline of bank risk-taking. We model risk-taking discipline using two measures: (1) the sensitivity of changes in bank capital to changes in bank risk; and (2) the observed risk-shifting behavior of banks. We find that discretionary provisioning in the form of earnings smoothing dampens disciplinary pressure on risk-taking, consistent with smoothing reducing bank transparency and inhibiting monitoring by outsiders. In contrast, discretionary provisioning practices that increase the extent to which current loan provisions explicitly anticipate future loan portfolio deterioration are associated with enhanced discipline of bank risk-taking.

A main message of our paper is that discretion over bank loan loss provisioning is a double-edged sword. While discretion may facilitate incorporation of more information about future expected losses into loan provisioning decisions and mitigate pro-cyclicality, it also increases potential for opportunistic accounting behavior by bank managers that can degrade bank transparency and lead to negative consequences for the discipline of bank risk-taking.

Although we cannot speak directly to specific alternative models proposed by bank policy makers, our results strongly suggest that great care must be exercised with respect to allowing more discretion into loan provisioning. Proposals to increase discretion in loan loss accounting embed significant risks of unintended consequences, as gains from reducing pro-cyclicality may be swamped by losses in transparency that dampen market discipline and increase the scope for less prudent risk-taking by banks.

The full paper is available for download here.