Using Loan Loss Indicators by Loan Type to Sharpen the Evaluation of Banks’ Loan Loss Accruals

Abstract

We provide evidence that the determinants of the primary loan loss indicators reported in financial reports — non-performing loans, the allowance and provision for loan losses, and net loan charge-offs — vary dramatically across real estate, commercial, and consumer loans, because these loan types differ in their homogeneity and collateralization and thus in the measurement of incurred losses under GAAP. Extending Wahlen (1994), we develop and estimate models of the non-discretionary and discretionary determinants of these loan loss indicators by loan type. The estimations indicate that banks’ exercise of discretion over provisions for loan losses is largely limited to heterogeneous commercial loans, a small slice of banks’ loan portfolios, and they provide many insights into the bank-specific and macroeconomic drivers of banks’ loan loss accruals. To demonstrate the increased statistical power and construct validity that results from conducting research on banks’ loan loss accruals by loan type, we show that this approach significantly improves the accuracy of out-of-sample predictions of future net loan charge-offs, more so for samples of banks whose loan portfolio composition varies more from that of the average bank. Our results illustrate the usefulness of disaggregated disclosures of loan loss indicators by loan type for future accounting research.