Abstract
During the late 1990’s, the SEC alleged that banks were overstating their loan loss allowances to establish cookie jar reserves and issued new guidance on allowance estimation designed to improve financial reporting quality. We show that banks’ estimation methods changed in response to the guidance and the changes significantly affected the informativeness of the allowances as proxied by their ability to explain future losses. While the SEC’s guidance has improved the informativeness of allowances for strong banks, it has had the opposite effect on Weak Banks whose incentives are to understate allowances. Our results help to explain why some (Weak) banks delayed loss recognition during the recent financial crisis.
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