Nonlinear Loan Loss Provisioning
48 Pages Posted: 1 Aug 2018
Date Written: July 31, 2018
Abstract
The extant banking literature often models loan loss provisioning as a linear function of changes in loan portfolio quality. Large sample data suggest that this linearity assumption is invalid. Using a piecewise linear specification, we find that while loan loss provisions increase almost proportionally with contemporaneous increases in nonperforming loans, they change less when nonperforming loans decrease. This asymmetric loan loss provisioning is not driven by the mechanical effects of loan charge-offs on nonperforming loans and allowance for loan losses. We show that loan loss provisioning asymmetry is greater for banks with shorter-maturity loan portfolios and more volatile interest income, and is more pronounced during economic downturns. Our proposed piecewise linear specification has a (moderately) higher power for detecting earnings management than standard linear models.
Keywords: loan collectibility, loan duration, conditional conservatism
JEL Classification: G21, G28, M41, M48
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