Delayed Expected Loss Recognition and the Risk Profile of Banks
ROBERT M. BUSHMAN, CHRISTOPHER D. WILLIAMS
Journal of Accounting Research · 2015 · Volume 53 · Issue 3
Abstract
This paper investigates the extent to which delayed expected loan loss recognition (DELR) is associated with greater vulnerability of banks to three distinct dimensions of risk: (1) stock market liquidity risk, (2) downside tail risk of individual banks, and (3) codependence of downside tail risk among banks. We hypothesize thatDELRincreases vulnerability to downside risk by creating expected loss overhangs that threaten future capital adequacy and by degrading bank transparency, which increases financing frictions and opportunities for risk-shifting. We find thatDELRis associated with higher correlations between bank-level illiquidity and both aggregate banking sector illiquidity and market returns (i.e., higher liquidity risks) during recessions, suggesting that highDELRbanks as a group may simultaneously face elevated financing frictions and enhanced opportunities for risk-shifting behavior in crisis periods. With respect to downside risk, we find that during recessionsDELRis associated with significantly higher risk of individual banks suffering severe drops in their equity values, where this association is magnified for banks with low capital levels. Consistent with increased systemic risk, we find thatDELRis associated with significantly higher codependence between downside risk of individual banks and downside risk of the banking sector. We theorize that downside risk vulnerability at the individual bank level can translate into systemic risk by virtue ofDELRcreating a common source of risk vulnerability across highDELRbanks simultaneously, which leads to risk codependence among banks and systemic effects from banks acting as part of a herd.
Keywords
G20, G21, M40, M41, bank, transparency, loan loss provisions, delayed loss recognition, risk, systemic risk
Enable JavaScript for citation tools and additional paper interactions.