Determinants of bank loan charge-off rates: evidence from the USA

Abstract

PurposeUsing data on 5,176 commercial banks in the USA for the period 1999Q1-2016Q3, the present study aims to examine the underlying determinants of loan charge-off rates.Design/methodology/approachThe study uses panel data fixed-effects estimation methodology.FindingsGreater regulatory capital, more diversification, higher profits and cost efficiency reduce charge-off rates. On the contrary, a higher share of loans in banks asset portfolio and a higher share of real estate loans have a detrimental impact on loan performance. Moreover, strong US macroeconomic fundamentals reduce loan charge-offs. Finally, real estate loan charge-offs are most sensitive to balance sheet conditions.Practical ImplicationsConsistent with Basel-III regulation, the results underscore the importance of banks to remain well capitalized. Greater tier-1 capital refrains banks from risky lending practices, thereby improving their loan performance. It is also important that banks maintain a diversified income stream and earn higher profitability. Finally, managerial inefficiencies leading to higher non-interest expense needs to be reduced to improve loan performance.Originality/valueAlthough a burgeoning body of literature has examined the underlying factors that affect poor quality loans in both the USA and elsewhere, fewer studies have focused on loan performance. From the perspective of banking regulation and fostering banking stability, determining the factors that affect loan charge-offs is extremely crucial to identify channels through which loan performance is either worsened or improved. If we understand poor loan performance, we can use that knowledge to anticipate the possibility of bankruptcy.