The determinants and value relevance of banks' discretionary loan loss provisions during the financial crisis

Abstract

We examine the economic determinants and value relevance of US banks' loan loss provisions (LLP) during the financial crisis. We consider whether LLP is determined by non-discretionary incurred loss variables only, or also by discretionary LLP (DLLP) that smooths reported earnings, signals favourable future earnings, or anticipates future losses. In a sample of 5187 bank-quarter observations from 2006 to 2010, our results show that LLP increases substantially, consistent with it being pro-cyclical, although LLP/equity levels remain modest. LLP severely and negatively impacts reported earnings, especially during 2009–2010. We also find that DLLP is used for smoothing and signalling, primarily where the two incentives reinforce each other, but smoothing occurs more frequently. Further, DLLP anticipated next quarter's losses in 2006–2008 but not in 2009–2010. The market positively values the use of DLLP in 2006–2008 to reduce reported earnings of poorly performing banks, and in 2009–2010 to smooth reported earnings of better performing banks.