Window dressing on bank problem loans: Evidence from natural disaster responses

Using natural disasters as shocks to local borrowers’ solvency, we investigate how banks’ post-shock reporting patterns of troubled assets are affected by their existing asset quality. We find that local banks with high nonperforming loan ratios tend to report fewer problem loans in financial statements upon facing natural disasters in the regions. These results are not driven by the banks’ stricter loan risk management, such as expanding origination of safer loans and cleaning up toxic assets through charge-off or disposal. We conclude that banks’ current loan quality is an important driver behind their use of managerial discretion in asset quality review to reduce reported problem loans in financial statements.