Abstract
Estimating expected credit losses on loan portfolios of banks has always been a difficult issue for investors, analysts and regulators when assessing the credit risk of banks. The issue has become of increasing interest to academics and regulators as the FASB and IASB debate new regulations on how to adjust their impairment regulations for loans, and as banking regulators increase their utilization of top down stress tests. This study develops a measure of next year’s expected rate of credit losses (ExpectedRCL) that is a combination of various relatively non-discretionary measures of credit risk disclosed by banks. ExpectedRCL performs substantially better than net charge-offs, realized credit losses, and fair value of loans in predicting credit losses, and reflects nearly all the credit loss-related information in these variables. ExpectedRCL also contains incremental information about future credit losses relative to the allowance and provision for loan losses. And, importantly, unlike the allowance or provision, it is unbiased.
Published Version
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