Do loan loss reserves behave like capital? Evidence from recent bank failures

Jeffrey Ng () and Sugata Roychowdhury ()
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Jeffrey Ng: Singapore Management University
Sugata Roychowdhury: Boston College

Review of Accounting Studies, 2014, vol. 19, issue 3, No 10, 1234-1279

Abstract: Abstract Regulatory capital guidelines allow for loan loss reserves to be added back as capital. Our evidence suggests that the influence of loan loss reserves added back as regulatory capital (hereafter referred to as “add-backs”) on bank risk cannot be explained by either economic principles underlying the notion of capital or accounting principles underlying the recording of reserves. Specifically, we observe that, in sharp contrast to the economic notion of capital as a buffer against bank failure risk, add-backs are positively associated with the risk of bank failure during the recent economic crisis. Furthermore, the positive association of add-backs with bank failure risk is concentrated among cases in which the add-backs are highly likely to increase a bank’s total regulatory capital. The evidence cannot thus be fully explained by accounting principles either, since the role of loan loss reserves according to those principles does not depend on whether the reserves generate a regulatory capital increase. Additional analysis suggests that the observed influence of loan loss reserves on bank failure risk may be an unintended consequence of their regulatory treatment as capital.

Keywords: Bank failure; Bank risk; Regulatory capital; Capital adequacy; Loan loss reserves; Loan loss provisions (search for similar items in EconPapers)
JEL-codes: G21 G28 G32 G38 M41 (search for similar items in EconPapers)
Date: 2014
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DOI: 10.1007/s11142-014-9281-z

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