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

Jeffrey Ng, Sugata Roychowdhury*

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

33 Scopus citations

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.

Original languageEnglish (US)
Pages (from-to)1234-1279
Number of pages46
JournalReview of Accounting Studies
Volume19
Issue number3
DOIs
StatePublished - Sep 2014
Externally publishedYes

Keywords

  • Bank failure
  • Bank risk
  • Capital adequacy
  • Loan loss provisions
  • Loan loss reserves
  • Regulatory capital

ASJC Scopus subject areas

  • Accounting
  • Business, Management and Accounting(all)

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