An information quality-based explanation for loan loss allowance inadequacy during the 2008 financial crisis

Abstract

I study whether commercial banks' loan loss allowances were inadequate during the 2008 financial crisis because bank managers relied on low-quality information to estimate loan losses. To measure the quality of information collected on bank-held mortgages prior to the crisis, I create a bank exposure-to-mortgage fraud risk index (EFI)<math><mrow is="true"><mi is="true">E</mi><mi is="true">F</mi><mi is="true">I</mi><mo stretchy="true" is="true">)</mo></mrow></math> that captures overstatement of borrower income in mortgage applications. I find banks that originated more loans in high-risk neighborhoods had less adequate loan loss allowances during the crisis. My study is consistent with the hypothesis that fraudulent borrower information adversely affected banks’ loan loss provisioning.