Does Uncertainty Matter for Loan Charge-Offs?
Posted: 17 Mar 2008 Last revised: 4 Feb 2015
Date Written: October 4, 2011
Abstract
Using a stylized real options model, we show that discretion over the timing of charging off a non-performing loan could be economically justified when collateral values are uncertain and there is a chance of loan recovery. The implied hypothesis of an "uncertainty dependence" aspect in loan charge-offs is empirically tested and validated using a panel of European banks. A welfare-maximizing regulator might want to let banks pursue such discretionary loan charge-off behavior, with the problem of distinguishing it from alternative capital management and income smoothing objectives, while transparency-seeking accounting standards setters would presumably not.
Keywords: discretion, loan charge-off, uncertainty dependence, real option
JEL Classification: G21
Suggested Citation: Suggested Citation