Delayed Expected Loss Recognition and the Risk Profile of Banks

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) co-dependence of downside tail risk among banks. We hypothesize that DELR increases 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 that DELR is 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 high DELR banks as 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 recessions DELR is 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 that DELR is associated with significantly higher co-dependence 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 of DELR creating a common source of risk vulnerability across high DELR banks simultaneously, which leads to risk codependence among banks and systemic effects from banks acting as part of a herd.