Bank accounting conservatism and bank loan quality

Abstract

AbstractThis study examines the effect of conditional conservatism in loan loss accounting—recognizing bad news in a timely fashion and deferring the recognition of gains—on a bank's own monitoring effort as reflected in its loan portfolio quality using a sample of publicly traded bank holding companies in the United States over the period 1994–2015. Sample banks adopting conservative loan loss accounting practices have lower nonperforming loans (NPLs) and lower net charge‐offs (NCOs), consistent with conservatism enhancing monitoring over lending decisions by improving financial transparency. The paper further finds that the effect of conservatism on loan quality is more pronounced for banks with high ex ante information asymmetry or distress risk and during low and high lending growth cycles, when loan quality is likely to deteriorate. Collectively, the findings suggest that conservative reporting reduces banks’ risk‐taking in lending. These findings should be of interest to regulators and policymakers who debate how to incentivize banks to use the discretion inherent in their loan loss provisioning in ways that are more informative and less opportunistic.