The Impact of Sarbanes–Oxley and Dodd–Frank Legislation on Loan Loss Provisioning in US Banks

Abstract

The Sarbanes–Oxley Act (SOX) of 2002 and the 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act (DFA) were passed to address weaknesses in the internal control environment of the firm. Elements of these Acts reduce risky behavior of financial institutions by reducing informational asymmetry with borrowers. An important element of managing earnings quality in financial institutions is the loss provision, an annual expense set aside for uncollected loan and lease payments. These Acts affect the selection of loss provision expense levels in distinct ways. Using a dataset of community bank financial information observed between 1998 and 2017, it is shown that banks experience a complementary effect between SOX and DFA on loss provision expenses. Improved governance procedures to establish policy responses to nonperforming loans result in reduced expenses, whereas reduced information asymmetry tends to enhance a moral hazard effect. These results show that incentives for firm growth, income, capital, and loan specialization under the SOX and DFA regulatory environments complicate the loan risk management process.