Delayed Expected Loss Recognition and the Risk Profile of Banks

• Date: 01 June 2015
• DOI: http://doi.org/10.1111/1475-679X.12079
• Author: CHRISTOPHER D. WILLIAMS,ROBERT M. BUSHMAN
• Published date: 01 June 2015

DOI: 10.1111/1475-679X.12079

Journal of Accounting Research

Vol. 53 No. 3 June 2015

Printed in U.S.A.

Delayed Expected Loss Recognition

and the Risk Profile of Banks

ROBERT M. BUSHMAN

∗AND CHRISTOPHER D. WILLIAMS

†

Received 27 July 2012; accepted 9 February 2015

ABSTRACT

This paper investigates the extent to which delayed expected loan loss recog-

nition (DELR) is associated with greater vulnerability of banks to three dis-

tinct dimensions of risk: (1) stock market liquidity risk, (2) downside tail

risk of individual banks, and (3) codependence of downside tail risk among

banks. We hypothesize that DELR increases vulnerability to downside risk by

creating expected loss overhangs that threaten future capital adequacy and

by degrading bank transparency, which increases financing frictions and op-

portunities for risk-shifting. We find that DELR is associated with higher cor-

relations between bank-level illiquidity and both aggregate banking sector

illiquidity and market returns (i.e., higher liquidity risks) during recessions,

suggesting that high DELR banks as a group may simultaneously face elevated

financing frictions and enhanced opportunities for risk-shifting behavior in

crisis periods. With respect to downside risk, we find that during recessions

DELR is associated with significantly higher risk of individual banks suffer-

ing severe drops in their equity values, where this association is magnified

for banks with low capital levels. Consistent with increased systemic risk, we

∗Kenan-Flagler Business School, University of North Carolina–Chapel Hill; †Ross School

of Business, University of Michigan.

Accepted by Philip Berger. Wethank R yan Ball, Mary Barth, Anne Beatty, Christian Leuz,

Mitch Petersen (discussant), an anonymous referee, and workshop participants at Harvard,

Seoul National University, University of Michigan, University of Minnesota Empirical Con-

ference, the JAR/NY Fed Pre-Conference, JAR/NY Fed Conference, Rice University, and

the Utah Winter Accounting Conference for helpful comments. Bushman thanks Kenan-

Flagler Business School, University of North Carolina at Chapel Hill, and Williams thanks

the PriceWaterhouseCoopers–Norm Auerbach Faculty Fellowship for financial support. We

also thank Tianshu Qu for valuable RA assistance.

511

Copyright C, University of Chicago on behalf of the Accounting Research Center,2015

512 R.M.BUSHMAN AND C.D.WILLIAMS

find that DELR is associated with significantly higher codependence between

downside risk of individual banks and downside risk of the banking sector.

We theorize that downside risk vulnerability at the individual bank level can

translate into systemic risk by virtue of DELR creating a common source of

risk vulnerability across high DELR banks simultaneously, which leads to risk

codependence among banks and systemic effects from banks acting as part of

aherd.

JEL codes: G20; G21; M40; M41

Keywords: bank; transparency; loan loss provisions; delayed loss recogni-

tion; risk; systemic risk

1. Introduction

Banks take on risks that are opaque and difficult to verify. Of particular

concern to bank regulators is excessive risk-taking by individual banks and

systemic risk, which requires a focus not on the risk of individual banks, but

on an individual bank’s contribution to the risk of the financial system as

a whole (e.g., Brunnermeier et al. [2009], Acharya et al. [2010], Hanson,

Kashyap, and Stein [2011], Bisias et al. [2012]). An important unresolved

issue is the extent to which bank transparency plays a role in mitigating

or exacerbating such risk concerns. We define bank transparency as the

availability of bank-specific information to those outside of the bank, which

includes depositors, investors, borrowers, counterparties, regulators, pol-

icy makers, and competitors.1A key source of bank transparency is pub-

licly disclosed financial reports, which provide bank-specific information

to investors and regulators seeking to understand a bank’s fundamentals

in order to guide investment decisions, discipline risk-taking, and enhance

stability. Accounting policy choices can therefore potentially affect bank

risk by impacting bank transparency. In addition to this transparency role,

accounting policy can affect bank stability through its influence over the

accounting numbers as quantitative inputs into numerical calculations of

regulatory covenant measures such as capital ratios and leverage ratios that

banks must continually maintain (e.g., Beatty and Liao [2011, 2014]).

In this paper, we investigate relations between banks’ accounting pol-

icy choices and both individual bank risk and risk codependence among

banks. We capture cross-bank variation in accounting policy choices by ex-

ploiting differences in the discretionary application of loan loss account-

ing rules across U.S. commercial banks to estimate the extent to which

individual banks delay expected loan loss recognition in current provisions

1Transparency is the joint output of a multifaceted system whose component parts collec-

tively produce, gather, validate, and disseminate information to participants outside the firm.

Components include audited, publicly available accounting information, information inter-

mediaries such as financial analysts, credit rating agencies and the media, regulatory reports

(including stress test disclosures), banks’ voluntary disclosures, and information transmitted

by securities prices (Bushman and Smith [2003], Bushman, Piotroski, and Smith [2004]).

DELAYED LOSS RECOGNITION AND THE RISK PROFILE OF BANKS 513

(DELR). We then use a difference in difference design to investigate the

extent to which DELR is associated with greater vulnerability of banks to

three distinct dimensions of risk during economic downturns: (1) liquidity

risk, which reflects how closely bank-level stock market illiquidity co-moves

with aggregate banking sector illiquidity and stock returns; (2) downside

tail risk of individual banks; and (3) codependence of downside tail risk

among banks (i.e., system-wide risk).

Reductions in transparency can induce greater investor uncertainty

about banks’ intrinsic value, weaken market discipline over risk-taking be-

havior, and mask banks’ efforts to suppress negative information that will

be revealed in future periods. Accounting policy choices can plausibly im-

pact bank transparency. We hypothesize that DELR is a manifestation of

opportunistic loan provisioning behavior, which results in reduced bank

transparency. To examine this hypothesis, we build on an extensive litera-

ture linking transparency to stock market illiquidity and liquidity risk (e.g.,

Amihud, Mendelson, and Pedersen [2005]). Liquidity risk reflects how

closely bank-level stock market illiquidity co-moves with aggregate bank-

ing sector illiquidity and stock returns. Brunnermeier and Pedersen [2009]

and Vayanos [2004] show that liquidity can dry up in crises when liquidity

providers flee from assets with high levels of uncertainty about fundamen-

tal value. Brunnermeier and Pedersen [2009] argue that systematic shocks

to the funding of liquidity providers can generate co-movement in liquidity

across assets, particularly for stocks with greater uncertainty about intrinsic

value. Further, Lang and Maffett [2011] empirically document that nonfi-

nancial firms with lower transparency suffer greater increases in liquidity

risk during crisis periods. Thus, to the extent that DELR reflects bank trans-

parency, we expect higher DELR to be associated with higher bank illiq-

uidity and liquidity risk, and that these associations will be stronger during

crisis periods. Consistent with our hypothesis, we find that DELR is associ-

ated with higher stock market illiquidity and a higher correlation between

bank-level illiquidity and aggregate banking sector illiquidity and returns

during recessions. 2While stock illiquidity generally increases during eco-

nomic recessions (Naes, Skjeltorp, and Arne Ødegaard [2011]), our results

show that recessionary increases in illiquidity and liquidity risk are more se-

vere for banks with higher levels of DELR.3This has important implications

for bank risk and stability.

First, illiquidity levels and liquidity risks associated with higher DELR

increase equity financing costs, which can impede access to new equity

2While we show a relation between DELR and equity financing frictions, DELR-driven opac-

ity may also negatively impact access to credit funding and the terms demanded by creditors

to supply such funding (e.g., Kashyap and Stein [1995, 2000], Ratnovski [2013]). This is an

important avenue for future research.

3Our within banking sector analysis of DELR and illiquidity complements Flannery, Kwan,

and Nimalendran [2013] across industry analysis showing that crises raise the adverse selection

costs of trading bank shares relative to nonbank control firms.