The Effect of Bank Loan Portfolio Composition on the Market Reaction to and Anticipation of Loan Loss Provisions

Abstract

We investigate how banks' loan portfolio composition affects the timeliness of loan loss provisions and, thus, the relation between security returns and such provisions. We maintain that the timeliness of loss provisions relative to other information about loan default decreases as discretion over such provisions increases, and that discretion over loss provisions varies by loan type. Bank managers have more discretion over loss provisions for large and frequently renegotiated loans, e.g., foreign and commercial loans, than for small or infrequently renegotiated loans, e.g., consumer loans. Large size and the possibility of renegotiation provide rationales for banks to provide for losses on a loan-by-loan basis rather than by statistical analysis of historical data. Using the proportion of small or infrequently renegotiated loans as a measure of the timeliness of loan loss provisions, we hypothesize and find that both the sign of the market reaction to and the strength of the market anticipation of loan loss provisions differs by this timeliness measure.'