The Nature of Information in Commercial Bank Loan Loss Disclosures

Commercial bank loan portfolios are typically 10 to 15 times larger than bank equity; therefore bank loan portfolio cash flows and default risks are likely to have an important impact on bank stock market values. Bank financial statements provide three separate disclosures of changing default risks:...

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Bibliographic Details
Published in:The Accounting review 1994-07, Vol.69 (3), p.455-478
Main Author: Wahlen, James M.
Format: Article
Language:English
Subjects:
Accounting
Bank capital
Bank loans
Bank management
Banking regulation
Cash flow
Coefficients
Commercial banks
Default
Disclosure
Information
Investors
Loan loss allowances
Loan losses
Loans
Mathematical models
Nonperforming loans
Studies
Tax writeoffs
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Summary:Commercial bank loan portfolios are typically 10 to 15 times larger than bank equity; therefore bank loan portfolio cash flows and default risks are likely to have an important impact on bank stock market values. Bank financial statements provide three separate disclosures of changing default risks: non-performing loans, loan loss provisions, and loan chargeoffs. This study analyzes each of these disclosures for information about future bank cash flows and examines how investors impound this information in bank stock prices. Non-performing loans include all loans in the portfolio more than 90 days overdue on interest or principal payments, and are disclosed as supplemental financial statement information. Loan loss provisions reflect the current period increase in the level of expected future loan losses, and are disclosed as accrued expenses on the income statement. Loan chargeoffs measure all loans deemed uncollectible during the period. Chargeoffs are asset writeoffs that are reported separately in financial statement footnotes, and can also be derived from balance sheet and income statement data. Together these three disclosures represent an integrated, contextual set of potentially value-relevant information spanning the income statement, balance sheet, and footnotes. Recent empirical studies obtain evidence consistent with a positive relation between stock returns and loan loss provisions (cf., Beaver et al. 1989; Elliott et al. 1991; Griffin and Wallach 1991; Johnson 1989). This evidence is surprising because it contradicts the notion that loan loss provisions are interpreted as expenses that reflect expected future loan losses. These papers conjecture that perhaps the market interprets provisions as revelations of bank managers' private information about expected future earnings, but do not test this idea. One potential explanation for these findings is that investors condition their interpretation of unexpected provisions on contemporaneous unexpected changes in non-performing loans and unexpected loan chargeoffs. These relatively non-discretionary pieces of loan loss information may enable investors to estimate discretionary components in unexpected loan loss provisions. If investors observe discretion being exercised over reported provisions, then they can make inferences about managers' private information. The conjecture of prior research is that investors infer that managers reveal "good news" when they exercise discretion to increase provisi
ISSN:0001-4826
1558-7967