The role of managerial prudence in bank loan loss provisioning.The recent market crisis has prompted greater awareness of the fragility of managerial estimates in bank financial statements. In the past, financial statement preparers were directed to employ conservatism in reported figures (Financial Accounting Standards Board Financial Accounting Standards Board (FASB)
Board composed of independent members who create and interpret Generally Accepted Accounting Principles (GAAP). , 2004). This practice could be perceived as favoring financial system stability because conservative accruals Accruals
Accounts on a balance sheet that represent liabilities and non-cash-based assets used in accrual-based accounting. These accounts include, among many others, accounts payable, accounts receivable, goodwill, future tax liability and future interest expense. during good times would build capital buffers and preserve solvency and maintain stable market confidence during times of financial system volatility. Through a joint project with international accounting standard setters, the U.S. Financial Accounting Standards Board (FASB FASB
See: Financial Accounting Standards Board
See Financial Accounting Standards Board (FASB). ) has recently eliminated the characteristic of conservatism from its accounting framework and adopted an unbiased estimate or neutral approach of accounting (FASB, 2010; Watts, 2003). Watts (2003b) cautioned accounting standard setters to make this change only after obtaining a clear understanding of potential ramifications ramifications npl → Auswirkungen pl of removing the element of conservatism. This study investigates the relationship between management prudence (a management characteristic or trait trait (trat)
1. any genetically determined characteristic; also, the condition prevailing in the heterozygous state of a recessive disorder, as the sickle cell trait.
2. a distinctive behavior pattern. characterized by a focus on the long-term viability of the enterprise) and accounting conservatism (a systematic approach to accounting that leads to a faster recognition of bad vs. good news as reflected in management's published accounting figures). While earnings management and loan loss provisioning has been extensively studied, prior studies have not evaluated the relationship between loss provisioning and characteristics of prudent management.
The characteristic of accounting conservatism, which Basu (1997) defines as early recognition of losses and delayed recognition of gains, has been extensively evaluated with respect to its relationship with negative attributes, such as hiding information from potential investors or regulators, smoothing earnings, or managing capital levels (e.g., LaFond and Watts, 2008; Liu and Ryan, 2006). To distinguish managerial prudence from accounting conservatism, this paper defines prudence as management's focus on the longterm viability of the organization and imprudence im·pru·dence
1. The quality or condition of being unwise or indiscreet.
2. An unwise or indiscreet act.
Noun 1. as management decisions that have been found to be associated with bank insolvency insolvency
Condition in which liabilities exceed assets so that creditors cannot be paid. It is a financial condition that often precedes bankruptcy. In the context of equity, insolvency is the inability to pay debts as they become due; insolvency under the balance-sheet . To summarize sum·ma·rize
intr. & tr.v. sum·ma·rized, sum·ma·riz·ing, sum·ma·riz·es
To make a summary or make a summary of.
sum , prudence/imprudence is a measure of how management's current decisions affect the long-term viability of the bank, whereas conservatism is a measure of how quickly the financial statements reflect the impact of management's imprudent im·pru·dent
Unwise or indiscreet; not prudent.
im·prudent·ly adv. actions. This study makes no claims about earnings management and does not investigate any deviation from a "natural" or "normal" level of accounting accruals. Rather, this study investigates if the loan loss provisions of prudent banking organizations appear to be different (either more or less conservative) than those of less prudent banking organizations.
This study attempts to isolate a managerial attribute and evaluate whether that attribute has a relationship with accounting accruals, specifically the loan loss provision. Finding an association would be consistent with the notion that managers use accruals to convey information about the nature of their organization's strategic view or other managerial traits. This study uses the bank setting because the loan loss provision is a well-documented managerial estimate and has been extensively studied (e.g., Kanagaretnam et al., 2004; Liu and Ryan, 2006). While other studies have evaluated accounting conservatism and accounting accruals in banks (e.g., Handorf and Zhu, 2006, Kanagaretnam et al., 2003; Kanagaretnam et al., 2004; Liu and Ryan, 2006), this study adds to the research on bank-specific accruals by investigating the link between accounting conservatism and management decisions.
Due to the lack of prior research defining quantitative attributes of management prudence in banks, this study develops a managerial prudence measure by isolating characteristics that have been associated with risky bank management behaviors and ultimately led to bank failures, according to according to
1. As stated or indicated by; on the authority of: according to historians.
2. In keeping with: according to instructions.
3. the Office of the Comptroller of the Currency The Office of the Comptroller of the Currency (or OCC) was established by the National Currency Act of 1863 and serves to charter, regulate, and supervise all national banks and the federal branches and agencies of foreign banks in the United States. (OCC), a banking regulator regulator,
n the mechanical part of a gas delivery system that controls gas pressure that allows a manageable flow of drug vapor to escape.
see reducing valve. (OCC, 1988), and other studies (e.g., Ahmed et al., 1999; Wheelock and Wilson, 2000). Therefore, an assumption is made that avoiding behaviors associated with bank failure can be used as a proxy for managerial prudence.
An analysis of the sample of commercial banks in this study shows that banks with less prudent management have higher subsequent ratios of quarterly provision expense to average loans than banks with more prudent leadership. This finding is consistent with less prudent management being less conservative in their accounting. Conservatism would require imprudent banks to reflect the impact of their current imprudent actions in the current period's provision expense. The finding that imprudent banks have higher subsequent provision expense is consistent with imprudent banks being less conservative in their accounting and therefore being required to make a larger provision expense in the subsequent period to "catch up." Furthermore, banks with less prudent management have less robust coverage of estimated losses within their loan loss allowance balances, which is consistent with the notion that banks with less prudent management insufficiently provide for identified nondiscretionary and other probable loan losses. These results lead to the conclusion that banks with less prudent management are more likely to need higher provisions to address loan loss estimate shortfalls, which could occur through insufficient provisions or through delays in recognizing loan quality declines.
This paper is organized as follows. The next section describes a bank manager's motivation for recognizing discretionary accounting accruals. Section 3 outlines the characteristics associated with prudent managerial leadership in banks. The research design is described in Section 4. Section 5 provides the study's results, and Section 6 outlines conclusions and suggestions for future work.
ACCOUNTING ACCRUALS IN BANKS
Generally Accepted Accounting Principles The standard accounting rules, regulations, and procedures used by companies in maintaining their financial records.
Generally accepted accounting principles (GAAP) provide companies and accountants with a consistent set of guidelines that cover both broad accounting require that loans (receivables) be reported at their net realizable value Net realizable value (NRV) is a commonly used method of evaluating an asset's worth in the field of inventory accounting. NRV is part of GAAP rules that apply to valuing inventory, so as to not overstate or understate the value of inventory goods. (NRV NRV New River Valley (NC, VA)
NRV Norddeutscher Regatta Verein (North German Regatta Association)
NRV Net Realizable Value
NRV Non Return Valve
NRV Net Reserve Value (accounting) ). NRV is the actual amount of cash that a bank expects to collect on its loan portfolio. NRV is equal to the total amount of loans outstanding less an estimate for the amount of the loans that will not be collected. The estimate of loans that will not be collected is recorded in the allowance for loan and lease losses (ALLL ALLL Allowance for Loan and Lease Losses ), a balance sheet (contra-asset) account. Each year, amounts are added to the ALLL based on management's estimate of future loan losses. Amounts are added to the ALLL by recording a charge against the bank's earnings, called the provision for loan losses (hereafter In the future.
The term hereafter is always used to indicate a future time—to the exclusion of both the past and present—in legal documents, statutes, and other similar papers. provision) which is an expense. When a bank confirms that a loan will not be collected, the uncollectible loans are first charged off against the ALLL (this charge off does not affect income or capital). If the ALLL is depleted de·plete
tr.v. de·plet·ed, de·plet·ing, de·pletes
To decrease the fullness of; use up or empty out.
[Latin d , additional credit losses would be absorbed by the bank's capital accounts (Wall and Koch, 2000). In a perfect world the yearly provision would represent expected credit losses due to loan activity during the current year. However, due to management's inability to estimate with perfect foresight (graphics, tool) Foresight - A software product from Nu Thena providing graphical modelling tools for high level system design and simulation. , future provisions are often increased or decreased as a "catch up" for past under/over provisioning.
When making accounting accrual accrual,
n continually recurring short-term liabilities. Examples are accrued wages, taxes, and interest. decisions, which includes provisioning, rational corporate leadership would balance personal benefits for selecting the most favorable fa·vor·a·ble
1. Advantageous; helpful: favorable winds.
2. Encouraging; propitious: a favorable diagnosis.
3. treatment against the risk of admonishment, possibly from declines in the company's stock price, or more directly from reduced remuneration REMUNERATION. Reward; recompense; salary. Dig. 17, 1, 7. tied to profits (LaFond and Watts, 2008). Earnings management in non-banking organizations is the subject of much research and debate (DuCharme et al., 2004; Givoly et al., 2007; Louis and Robinson, 2005). Studies have attempted to understand whether earnings have been managed and what incentives prompted earnings management (Kothari et al., 2005).
There have been some initial steps to identify and measure the strength of corporate governance Corporate Governance
The relationship between all the stakeholders in a company. This includes the shareholders, directors, and management of a company, as defined by the corporate charter, bylaws, formal policy, and rule of law. attributes and how these characteristics influence accounting accruals, information quality, and future earnings prospects (Larcker et al., 2007). Accruals evaluation techniques, which are similar to those used in Larcker et al. (2007), are used in this study. However, this study specifically targets behaviors that could be associated with imprudent behavior, while the Larcker et al. (2007) study covers a broad spectrum of fourteen characteristics of members from boards of directors.
Typically, a bank's loan portfolio represents about 60% of its total assets and commonly represents a bank's riskiest investment (Basu, 2003). Excessive loan losses or bank leadership's ineffectiveness in managing the risks associated with the loan portfolio can cause bank failure (Beattie et al., 1995; OCC, 1988). When a bank confirms that loans are worthless, the losses are first absorbed by the bank's allowance for loan and lease losses (ALLL) (2) (Wall and Koch, 2000). If the ALLL is depleted, losses would be absorbed by a bank's capital accounts (Wall and Koch, 2000). If a bank is unable to generate sufficient earnings to replenish re·plen·ish
v. re·plen·ished, re·plen·ish·ing, re·plen·ish·es
1. To fill or make complete again; add a new stock or supply to: replenish the larder.
2. the loss allowance account and capital accounts, the government may intervene to protect the bank's depositors through the Federal Deposit Insurance Corporation's insurance fund (Wall and Koch, 2000).
A bank's manager must balance conflicting pressures concerning ALLL levels, as various users of reporting information have divergent di·ver·gent
1. Drawing apart from a common point; diverging.
2. Departing from convention.
3. Differing from another: a divergent opinion.
4. desires to seek either higher or lower levels of loss estimates (Gray and Clarke, 2004). According to accounting guidance and bank supervisory guidance, bank management is encouraged to use judgment when estimating loan loss (Securities and Exchange Commission, 2001). Bank management's responses to these standards and guidance have prompted some to believe that the level of the ALLL is managed by bankers to smooth earnings, manipulate capital, or signal the stock market (Beattie et al., 1995; Gray and Clarke, 2004; Kanagaretnam et al., 2004). Research has been conducted to determine whether bankers use the ALLL to achieve desired financial outcomes. The results of extant ex·tant
1. Still in existence; not destroyed, lost, or extinct: extant manuscripts.
2. Archaic Standing out; projecting. research are inconclusive INCONCLUSIVE. What does not put an end to a thing. Inconclusive presumptions are those which may be overcome by opposing proof; for example, the law presumes that he who possesses personal property is the owner of it, but evidence is allowed to contradict this presumption, and show who is or divergent. Furthermore, much of the research that evaluates discretionary expenses is designed to understand whether management intentionally in·ten·tion·al
1. Done deliberately; intended: an intentional slight. See Synonyms at voluntary.
2. Having to do with intention. deceives the market or manipulates accounting data for personal gain. Research designed to determine whether the extent of management prudence is a predictor of accrual levels is limited, with no recently published studies evaluating this relationship in banks.
MANAGEMENT PRUDENCE IN BANKS
Adam Smith defined prudence as a virtue relating to relating to relate prep → concernant
relating to relate prep → bezüglich +gen, mit Bezug auf +acc the proper care of an individual's health, fortune, rank and reputation. Smith noted it is the virtue of the sound banker that commanded "a certain cold esteem" (Smith, 1969/1853: 6). Based on this definition from Smith, this paper defines management prudence as management's focus on the long-term viability of the organization. Therefore, management attributes associated with bank failures are classified as imprudent, and the reciprocal of those attributes is used as a proxy for management's focus on the long-term viability of the bank, prudent. A search of the academic literature has not identified any prior research that has used a managerial prudence construct similar to what is used in this paper. (3) In accounting terms, conservatism is defined as "a prudent reaction to uncertainty to try to ensure that uncertainty and risks inherent in business situations are adequately considered" (FASB, 2007: 38). In practice, accounting conservatism is implemented by using estimates that would tend to understate un·der·state
v. un·der·stat·ed, un·der·stat·ing, un·der·states
1. To state with less completeness or truth than seems warranted by the facts.
2. current levels of income and assets when there is uncertainty regarding future outcomes. Using these definitions, prudence is distinct from the accounting concept of conservatism. Prudence involves the investment and credit decisions that management make, while conservatism refers to how uncertainty relating to the future outcomes of the investment and credit decisions made by the manager are reflected in the current financial statements. While the concepts are distinct, it is expected that managers, who make decisions that are less prudent, are also likely to be less conservative in their application of accounting principles.
Accounting conservatism research has traditionally focused on measuring the timing of accruals (Givoly et al., 2007). In 1997, Basu advanced an interpretation of accounting conservatism that has been validated in more recent studies (Roychowdhury and Watts, 2007). Basu (1997) interpreted accounting conservatism as an expedient ex·pe·di·ent
1. Appropriate to a purpose.
a. Serving to promote one's interest: was merciful only when mercy was expedient.
b. response to negative information and a slow response to positive information (e.g., expenses and losses are recognized sooner than are revenues and gains). A similar definition of accounting conservatism is the tendency to make accounting decisions that will result in the lowest book value of equity (Roychowdhury and Watts, 2007). (4)
Results of studies evaluating management attributes and accounting conservatism have come to conflicting conclusions. For example, Larcker et al., (2007) concluded that none of the governance characteristics, which they evaluated, have significant relationships with an accounting conservatism indicator, while Ahmed and Duellman (2007) concluded that board of director members rely upon accounting conservatism to modify decision-making.
Bank-specific studies that have evaluated motivation and accounting conservatism have drawn conflicting conclusions (Kanagaretnam et al., 2004), with inconsistent results. While some studies conclude that earnings management is evident (Handorf and Zhu, 2006; Liu and Ryan, 2006), others conclude that management does not manage earnings through accrual manipulation (Ahmed et al., 1999; Beatty et al., 1995). These prior studies do not evaluate characteristics of managerial prudence and accruals. To address this apparent research gap, this study isolates attributes of prudent bank management, and evaluates the relationship between the prudence indicator and bank accounting accruals (specifically, the provision).
Design of the Prudence Indicator
Much of the research on bank failures is conducted on data from the period immediately following the late 1980s and early 1990s, because many banks failed during that period. Bank failures increased during this time, ill part, because of weakened economic conditions. In particular, geographic areas were affected by declines in regionally influential sectors, such as the agriculture or oil and gas industries (Wheelock and Wilson, 2000). However, many banks survived these influences, which supports a presumption A conclusion made as to the existence or nonexistence of a fact that must be drawn from other evidence that is admitted and proven to be true. A Rule of Law.
If certain facts are established, a judge or jury must assume another fact that the law recognizes as a logical that attributes besides a bad economy are the ultimate cause of bank failures. While it is likely that poor management decisions are ultimately the reason for bank failures (OCC, 1988), management characteristics are difficult to quantify Quantify - A performance analysis tool from Pure Software. (Wheelock and Wilson, 2000). Therefore, studies that evaluate bank failures include variables that are more readily quantifiable, such as lending to risky borrowers, proportions of types of investment holdings, loss provisioning tendencies, and capital levels (Wheelock and Wilson, 2000). Five quantifiable attributes related to how a bank is managed are used to construct a measure of prudence. The five characteristics selected as components for this study's Prudence Indicator (PI) are discussed in the following sections.
Loan Growth Factor
A significant and common characteristic of banks that failed during the 1980s is an aggressive lending philosophy (OCC, 1988). This factor is also identified by Hanc (1997) as a feature that differentiated troubled banks that failed from those that did not fail during the 1980s and early 1990s. Additionally, Ahmed et al. (1999) conclude that banks with high loan growth faced greater pressure to address lower capital ratios and managed their capital positions through discretionary, loan loss provisions. Basu (2003) suggests that banks that aggressively compete with other banks for growth may have a tendency to underprice un·der·price
tr.v. un·der·priced, un·der·pric·ing, un·der·pric·es
1. To price lower than the real, normal, or appropriate value.
2. loans and may have a higher risk of failure. Bank supervisors utilize risk measurement models to predict bank insolvency that have traditionally focused on excessive loan growth (King et al., 2006).
Interest and Fees on Loans Factor
Another characteristic that is common to banks that failed in the 1980s and 1990s is a high ratio of interest and fees to loans (Hanc, 1997; Wheelock and Wilson, 2000). High ratios of interest and fees to loans could indicate that a bank was assuming excessively high credit risk. Banks with high ratios of interests and fees on loans may be taking greater credit risks than those banks with low ratios of interest and fees on loans. Oshinsky and Olin (2005) conclude that troubled banks that failed invested in riskier assets than troubled banks that did not fail, as evidenced by significantly higher interest and fee income in troubled banks that failed.
Salary to Employee Ratio Factor
Hanc (1997) concludes that banks with highly-compensated management have a greater tendency to fail. Additionally, Kanagaretnam et al. (2003) conclude that bank managers are influenced by job security when making accounting choices. Therefore, individuals with a greater aversion a·ver·sion
1. A fixed, intense dislike; repugnance, as of crowds.
2. A feeling of extreme repugnance accompanied by avoidance or rejection. to loss of compensation may have greater incentive to behave in a more prudent manner. Based on these findings, it is expected that a higher salary to employee ratio indicates that bank management is more willing to assume risks and is therefore less prudent.
High Risk Loans Factor
Banks were more susceptible to failure in the 1980s and 1990s if they had a high proportion of loans to total assets (Hanc, 1997; Thomson, 1991; Wheelock and Wilson, 2000). Banks with high proportion of loans to total assets increased their risk of failure by making high levels of loans to risky business sectors (OCC, 1988). The ratio of commercial and industrial (C&I) loans to total loans is a proxy for credit risk in the loan portfolio. C&I loans are typically less marketable than credit card and mortgage loans, and a high proportion of C&I loans is a characteristic that differentiated failed from surviving banking organizations (Greenawalt and Sinkey, 1988; Wheelock and Wilson, 2000). Additionally, Beatty et al. (2002) conclude that banks record provisions at higher levels when they have greater proportions of commercial loans, which may indicate that commercial loans carry greater credit risk. Furthermore, these types of loans have had higher historic loss rates over the period of this study than other significant types of bank loans, such as real estate loans ("Charge-off and Delinquency delinquency
Criminal behaviour carried out by a juvenile. Young males make up the bulk of the delinquent population (about 80% in the U.S.) in all countries in which the behaviour is reported. Rates," 2005), and have been attributed to increasing the risk of bank failures (Oshinsky and Olin, 2005; Wheelock and Wilson, 2000). Therefore, banks with lower than average C&I loans to total loans ratios are expected to have more prudent management. Additionally, the proportion of C&I loans is one of the variables considered in the Federal Reserve System's bank failure prediction model (King et al., 2006).
Recoveries to Prior Period Loan Losses Factor
Bankers are directed to charge off loans before they are considered totally uncollectible or worthless (Board of Governors of the Federal Reserve System, 2006). When a loan is repaid after it has been charged off, a banker reports a recovery for the amount paid (Federal Financial Institutions Examinations Council, 2006). A higher than average ratio of recoveries to the prior period's losses (R/PPLL ratio) could indicate that management was willing to charge off loans expeditiously ex·pe·di·tious
Acting or done with speed and efficiency. See Synonyms at fast1.
ex and recognize a recovery if the borrower decided to repay the loan. Alternatively, a high ratio could indicate that bank management was expeditiously charging-off loans in response to directives made by banking supervisors. In either case, banks with a high R/PPLL ratio are expected to have more prudent management.
Calculating the Prudence Index
Each bank within the sample receives a prudence index calculated from the five prudence factors described above. For each firm quarter observation, the factors are calculated and each bank's percentile ranking is determined. Each bank's percentile ranking for each factor is aggregated and the mean of the factors determines the prudence indicator (Pi). The equation to determine the Pi is as follows:
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII ASCII or American Standard Code for Information Interchange, a set of codes used to represent letters, numbers, a few symbols, and control characters. Originally designed for teletype operations, it has found wide application in computers. .]
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII.]
A summary of the order of influence for the characteristics within the Pi is in Table 1. An evaluation of the descriptive statistics descriptive statistics
see statistics. of the Pi factors indicates that no single factor appears to overwhelmingly influence the Pi in the aggregate nor when grouping the prudent or imprudent observations into subsamples. Additionally, no one factor was inconsequential in·con·se·quen·tial
1. Lacking importance.
2. Not following from premises or evidence; illogical.
A triviality. in the aggregate or in the subsamples.
Once the Pi is determined, a dummy variable This article is not about "dummy variables" as that term is usually understood in mathematics. See free variables and bound variables.
In regression analysis, a dummy variable is assigned for managerial prudence for each firm quarter observation. The dummy variable, called the Prudence Indicator (PI), is 1 if Pi [greater than or equal to] 0.50 and 0 if Pi < 0.50 (5). The scores are interpreted as follows: banks with prudent management are identified as 0 and banks with imprudent management are identified as 1.
The Pi and PI are calculated for a sample of all public and nonpublic commercial banks with total assets greater than $10 million (except for banks chartered less than five years) that filed Reports of Condition and Income (aka "Call Report") with United States United States, officially United States of America, republic (2005 est. pop. 295,734,000), 3,539,227 sq mi (9,166,598 sq km), North America. The United States is the world's third largest country in population and the fourth largest country in area. federal banking supervisors. The time frame encompassed quarterly data reported from December 31, 1984 through December 31, 2004. The number of commercial banks evaluated ranged from nearly 8,000 at the end of 1984 to about 4,800 at the end of 2004 for the 81 quarters identified. The number of firm-quarter observations in the final sample was 544,072.
The PI developed in the previous section measures the extent to which the bank's management is taking actions in the current period that will increase future credit losses. This paper hypothesizes that managers that are imprudent are less conservative in recognizing the increased credit risk in the loan portfolio in the bank's current-period provision. Conservative accounting would recognize an increase in the provision in the same period that the imprudent decisions are made. If a manager is less conservative in applying accounting principles, the increase in the provision will be delayed to future period(s) and will be recorded as "catch up" adjustment. This leads to the hypothesis tested in this paper:
HI: Banks with managers who are classified as imprudent in the current period will have higher future provisions for loan and lease losses than banks with managers who are not classified as imprudent.
Accounting for Loan Losses
This study relies upon the work of Wahlen (1994) as advanced by Kanagaretnam et al. (2003) and Kanagaretnam et al. (2004). In Wahlen (1994), the current year's provision is a function of three elements: (1) the beginning balance of the ALLL, (2) nonperforming loans at the beginning of the period and the change in nonperforming loans during the period, and (3) total loans outstanding of the six major categories of loans at the beginning of the period. Subsequent studies have relied upon this initial definition of nondiscretionary provisions (Beatty et al., 1995; Beatty et al., 2002; Kanagaretnam et al., 2003; Kanagaretnam et al., 2004; Kim and Kross, 1998), with some modification. This paper adds to Wahlen (1994) by adding a variable to examine the effect of managerial prudence on the provision. A discussion of the three variables used in Wahlen (1994), which are used to control for the nondiscretionary portion of the provision in this study, follows.
The Beginning Balance of the ALLL
The beginning of the period ALLL represents management's expectations of estimated loss at the beginning of the period, and historic loss estimates generally predict future provisioning behaviors (Wahlen, 1994). Additionally, this variable should explain whether the ALLL is either over or under funded in the prior year (Beatty et al., 1995). This variable should be negatively associated with provisions because the bigger the balance of the combined historical discretionary and nondiscretionary ALLL is at the beginning of a period, the lower the nondiscretionary provision expense needs to be in the following period (Kanagaretnam et al., 2004).
Non-performing loans are loans with payment in arrears Adv. 1. in arrears - in debt; "he fell behind with his mortgage payments"; "a month behind in the rent"; "a company that has been run behindhand for years"; "in arrears with their utility bills"
behindhand, behind by at least 90 days. The total of non-performing loans can be used as a proxy for the level of loan quality within the portfolio (Beatty et al., 2002). Expected behaviors for provisioning include an understanding of provisioning for both historical non-performing loans and the change in non-performing loans that occurs within the period (Wahlen, 1994). In other words Adv. 1. in other words - otherwise stated; "in other words, we are broke"
put differently , as the level of non-performing loans within a loan portfolio increases, the provision for loan losses should also increase. The opposite should also be true. As the level of nonperforming loans within the portfolio decreases, the provision should decline.
Total Loans Outstanding
Wahlen (1994) assumes that the aggregate number of loans outstanding in six predominant loan categories would explain the migration of loans into riskier categories over the period. Kanagaretnam et al. (2004) include a variable for the change in total loans outstanding, and hypothesize hy·poth·e·size
v. hy·poth·e·sized, hy·poth·e·siz·ing, hy·poth·e·siz·es
To assert as a hypothesis.
To form a hypothesis. that the relationship between this variable and provisioning behavior would depend upon the quality of new loan growth. Others have included this variable to measure overall loan growth and have assumed that loan growth would require a larger ALLL, which would result in an increase in the provision (Beaver beaver, either of two large aquatic rodents, Castor fiber and Castor canadensis, known for their engineering feats. They were once widespread in N and central Eurasia except E Siberia, and in North America from the arctic tree line to the S United and Engel, 1996; Kanagaretnam et al., 2003). By this same logic, shrinkage Shrinkage
The amount by which inventory on hand is shorter than the amount of inventory recorded.
The missing inventory could be due to theft, damage, or book keeping errors. in the loan portfolio would necessitate ne·ces·si·tate
tr.v. ne·ces·si·tat·ed, ne·ces·si·tat·ing, ne·ces·si·tates
1. To make necessary or unavoidable.
2. To require or compel. a smaller ALLL and a lower provision (Beaver and Engel, 1996; Kanagaretnam et al., 2003). In this study, a loan growth ratio (ATL (Active Template Library) A set of software routines from Microsoft that provide the basic framework for creating ActiveX and COM objects. Stemming from the standard template library (STL) that comes with C++ compilers, ATL includes an object wizard that sets up ) is included to explain that growth should be accompanied by directionally consistent changes in the provision. Movements toward riskier loans within the loan portfolio should be explained by the PI. Table 2 presents descriptive statistics for the sample. The mean of scaled, annualized annualized
Of or relating to a variable that has been mathematically converted to a yearly rate. Inflation and interest rates are generally annualized since it is on this basis that these two variables are ordinarily stated and compared. , loan loss provision expense is consistent with other studies of loan loss provisioning behaviors (Ahmed et al., 1999; Kanagaretnam et al., 2004). While the level of negative provisions for this sample is larger than other studies, a review of the data reveals that negative provisions have been more prevalent in the last five years of data used in this study, and earlier studies do not include these more recent years. For example, Ahmed et al. (1999) evaluate the time frame between 1987 and 1995, and Kanagaretnam et al. (2004) between 1980 and 1997. Kanagaretnam et al. (2003) eliminate observations with low or negative provisions. Since this study evaluates prudent behavior characteristics, potentially aggressive behaviors may be important to include in the data set; therefore, low and negative provisions are retained in the data set.
Regression Equation Regression equation
An equation that describes the average relationship between a dependent variable and a set of explanatory variables.
Based on the above considerations, the following regression equation is used to determine whether a relationship exists between the loan loss provision and managerial prudence:
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII.]
i = bank
t = time
ALLL = Allowance for loan and lease losses
LLP LLP - Lower Layer Protocol = Loan loss provision expense
NPL 1. NPL - New Programming Language. IBM's original (temporary) name for PL/I, changed due to conflict with England's "National Physical Laboratory." MPL and MPPL were considered before settling on PL/I. Sammet 1969, p.542.
2. = Nonperforming loans
ANPL = Change in the value of nonperforming loans since the prior period
ATL = Change in total loans since the prior period
PI = Prudence indicator (prudent management = 0 and imprudent management = 1)
E = Error term
[a.sub.0] = Intercept for prudent management
Consistent with Kanagaretnam et al. (2003), this study deflates all independent variables, except for the PI, by the balance of outstanding loans at the beginning of the period.
Coefficients for the Nondiseretionary Independent Variables
As Table 3 shows, the coefficient coefficient /co·ef·fi·cient/ (ko?ah-fish´int)
1. an expression of the change or effect produced by variation in certain factors, or of the ratio between two different quantities.
2. for the beginning of the period balance of the ALLL (-0.033) is negative and statistically different from zero (p-value = 0.0237). This variable measures the amount of the ALLL that had been previously recorded with a provision through earnings but had not yet been eliminated through a charge-off of a problem loan. The ALLL balance would be available for any loan charge-off; therefore, if the ALLL balance were high, there would be less need for additional future provisions.
The coefficients for the beginning of the period nonperforming loans (0.086) and the change in nonperforming loans (0.035) are both positive and statistically significant. These variables measure the level of poor quality loans within the portfolio at the beginning of the period and the changes in the level of poor quality loans during the period. The positive relationships of these variables with the dependent variable LLP are as expected, as higher levels of non-performing loans necessitate greater future loss provisions (Kanagaretnam et al., 2003). After controlling for heteroscedasticity, the coefficient for loan growth (ATL) is positive (0.001) but not significant (p-value < 0.2108).
While the commercial loans to total loans ratio measures prudence, it could also measure credit risk and be correlated cor·re·late
v. cor·re·lat·ed, cor·re·lat·ing, cor·re·lates
1. To put or bring into causal, complementary, parallel, or reciprocal relation.
2. with the other independent variables. In order to evaluate whether this prudence factor is correlated with the other variables and potentially biases the results, the Pi factor and regression results are calculated without the commercial loans to total loans ratio factor. The outcome of this test indicates that the revised regression results do not change when the C&I factor is excluded. Furthermore, to test for correlation between the PI and the other independent variables in the final regression equation, the Pearson Correlation Coefficient Correlation Coefficient
A measure that determines the degree to which two variable's movements are associated.
The correlation coefficient is calculated as: test is used. There is no evidence of correlation, which further supports the conclusion that the results are not biased by including the commercial loans to total loans ratio as a factor in the Pi.
Coefficient for the PI
The coefficient on PI is positive (0.04269) and statistically significant (p-value < 0.0001). This relationship may seem contrary to expectations, because one might expect prudent management to over-provide for losses. However, LLP is measured at time (t) while PI is measured at time (t-1), indicating that imprudent management is recognizing the losses later than more prudent management. Conversely con·verse 1
intr.v. con·versed, con·vers·ing, con·vers·es
1. To engage in a spoken exchange of thoughts, ideas, or feelings; talk. See Synonyms at speak.
2. , prudent managers recognize losses sooner. This finding is consistent with management becoming less prudent and less conservative in accounting by delaying the recognition of the increased risk in the provision. Imprudent management may lack diligence in recognizing problem loans and may increase provisions to compensate for problems that are not identified in a timely manner and are not included as part of the nondiscretionary provisions. Alternatively, imprudent bankers may not sufficiently provide for identified nondiscretionary loss estimates. These findings support the view that imprudent bankers may have been compelled to provide at higher levels in order to address past provisioning shortfalls. All bank managers are eventually required to provide a reasonable ALLL to maintain a satisfactory bank rating from the regulator and to satisfy the auditor (Douthett et al., 2001).
Additional evidence is obtained by examining the ratio of non-performing loans to ALLL and the ALLL as a percentage of total loans, for both prudent bank observations and imprudent bank observations. This analysis reveals, on average, the banks with less prudent management have lower coverage ratios of both non-performing loans and of total loans. These results indicate that while imprudent managers may periodically recognize larger annual provisions, the increase in the annual provision lags behind management's more aggressive (less prudent) actions. Additionally, the lower coverage ratios pertaining per·tain
intr.v. per·tained, per·tain·ing, per·tains
1. To have reference; relate: evidence that pertains to the accident.
2. to the ALLL as a percentage of total loans and non-performing loans indicate that banks with imprudent management face a greater likelihood of having an inadequate ALLL to provide for known losses.
CONCLUSIONS AND IMPLICATIONS
Prudence, defined as the extent of bank management's focus on the long-term viability of the organization, is associated with loan loss provisioning behaviors. Banks with less prudent leadership have subsequent higher ratios of quarterly provision expense to average loans than banks with prudent leadership. Furthermore, banks with imprudent leadership have less robust coverage of estimated losses within their loan loss allowance balances, which suggests that banks with imprudent leadership did not sufficiently provide for identified nondiscretionary and other probable loan losses. In other words, imprudent managers delay the recognition of loan loss provisions that are needed due to changes in loan quality.
This study indicates that managerial prudence influences accounting decisions with respect to loan loss estimates. Now that this relationship is established, studies designed to evaluate this association over a time-series or when loan quality is stressed appear warranted. Furthermore, future studies that evaluate the relationship between bank loan loss provision behaviors and earnings projections, stock price movements, or compensation contracts may consider including the effects of managerial prudence within their results.
Future research should be conducted to more fully understand the concept of prudence and its relationship with loan loss provisioning. Research on the relationship between management culture and accounting conservatism is particularly important considering the shift in accounting's conceptual framework For the concept in aesthetics and art criticism, see .
A conceptual framework is used in research to outline possible courses of action or to present a preferred approach to a system analysis project. from conservative principles to an unbiased estimate approach without a full understanding of the potential information that could be lost as a result of this change (Watts, 2003a). The results of this study indicate that the extent of managerial prudence influences provisioning behaviors within the current conservative accounting framework. Furthermore, the results suggest that imprudent leadership may provide insufficient amounts for identified problem loans.
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(1) The authors appreciate the helpful comments of the Editor and two anonymous reviewers on prior drafts of this paper.
(2) This allowance is also commonly referred to as the reserve for loan losses and, internationally, as the provision account. It refers to the amount on a bank's balance sheet that represents the estimated incurred losses inherent within the bank's loan portfolio. The balance decreases through charging off bad loans and increases through provision expenses taken through a bank's income statement or through recoveries on prior period loan losses.
(3) The concept of prudence has been studied previously in banks. However, typically the concept of prudence is studied in the context of "prudent regulation" or prudent investment choices relying on the legal concept of the "prudent man."
(4) Watts (2003a) suggests there are four primary reasons to employ conservative accounting behaviors. The first three apply to management and their information environment and the last applies to the accounting standard setters and securities regulators. First, there are contracting benefits associated with conservative accounting practices. Second, managers may be conservative in response to the threat of shareholder suits and claims of aggressive accounting practices. Third, conservative accounting techniques could lower tax liabilities and conform to Verb 1. conform to - satisfy a condition or restriction; "Does this paper meet the requirements for the degree?"
coordinate - be co-ordinated; "These activities coordinate well" tax strategies. Fourth, accounting standard setters and securities regulators may support conservative accounting standards in response to a public preference for conservatism. Watts (2003b) puts forth these potential explanations for conservative accounting behaviors and suggests that conservative accounting practices may be motivated by reasons that are both self-serving and efficient given the costliness of information.
(5) The 0.50 cutoffs used for the PI index are arbitrary. Other possible classification schemes could focus on the more extreme measures of Pi. Using cutoffs that focus on observations in the ends of the distributions increases the probability of finding results. The 0.5 cutoff is a reasonable starting point Noun 1. starting point - earliest limiting point
terminus a quo
commencement, get-go, offset, outset, showtime, starting time, beginning, start, kickoff, first - the time at which something is supposed to begin; "they got an early start"; "she knew from the given that the PI index is new to the literature.
Linda V. Ditchkus *
University of Phoenix
Retired, Federal Reserve Board of Governors
Gregory E. Sierra
Assistant Professor of Accounting
Southern Illinois University Edwardsville
Brad J. Reed
Professor of Accounting
Southern Illinois University Edwardsville
* The opinions expressed here do not necessarily represent those of the Federal Reserve Board of Governors or the Federal Reserve System.
Table 1 Prudence Indicator Factors Ranked by Order of Influence Prudence Factor Proportion of commercial and industrial loans (COMPROP) Salary expense ratio (SAL) Growth (GROWTH) Interest and fees on loans to average loans (INT) Recoveries to prior period loan losses (RECOV) [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII.] Data are taken from "Call Reports" (reporting forms FFIEC 031 and FFIEC 041), which are regulatory filing of U. S. commercial banks. All data are publicly available. For more information on the Call Report see the Federal Financial Institutions Examination Council's (FFIEC) web site at ffiec.gov. Specific Call Report Variable Identification Numbers are as follows: Commercial and industrial loans (RCFDI600), total loans (RCFD2122), salary expense (RIAD4135), full-time staff equivalent (FIAD4150), total assets (RCFD2170), interest and fees on loans (RIAD4010), average loans (RCFD3360), charge-off recoveries (RIAD4605), and loan losses (RIAD4230). Table 2 Descriptive Statistics Descriptive statistics for the sample of commercial banks, with total assets of greater than $10 million, except for newly chartered banks, that filed Reports of Condition and Income with United States Federal banking supervisors Variable Mean SD Median Min Max LLP 0.2095 0.5838 0.0849 -63.0037 114.8985 ALLL 1.6338 1.0256 1.3639 0.0000 94.3112 N PL 1.9746 2.4919 1.1652 0.0000 83.1202 [DELTA]NPL -0.0079 1.2091 -0.0091 -37.1701 159.9798 Growth 0.0205 0.1338 0.0125 -0.9345 21.2932 PI Index 50.0479 13.2760 49.8000 4.4000 98.0000 Data are taken from "Call Reports" (reporting forms FFIEC 031 and FFIEC 041), which are regulatory filing of U. S. commercial banks. All data are publicly available. For more information on the Call Report see the Federal Financial Institutions Examination Council's (FFIEC) web site at ffiec.gov. All data are publicly available except those items related to the aging schedule of loans receivable (items RCFD 1407 and RCFD 1403). LLP: Loan loss provision expense (RIAD4230) scaled by beginning of the period total loans (RCFD2122). ALLL: Allowance for loan and lease losses (RCFD3123) scaled by beginning of the period loans (RCFD2122). NPL: Non-performing loans, which includes loans delinquent greater than 90 days (RCFD1407 + RCFD1403), scaled by beginning of the period loans (RCFD2122). [DELTA]NPL: Change in the value of non-performing loan since the prior period scaled by beginning of the period loans (see definition of NPL Ratio). Growth: Total assets at the end of the period (RCFD2170)--total assets at the beginning of the period scaled by total assets at the beginning of the period. PI Index: Prudence Indicator (see Table 1). Table 3 Regression Results for the Entire Sample Variable Parameter T statistics P values Expected Estimate Coefficient Intercept 0.7363 3.10 0.0010 + ALLL -0.03322 -1.98 0.0237 - NPL 0.08561 32.94 <0.0001 + [DELTA]NPL 0.03471 4.63 <0.0001 + [DELTA]TL 0.00064 0.80 0.2108 + PI 0.04269 29.36 <0.0001 + Variable Resulting Coefficient Intercept + ALLL - NPL + [DELTA]NPL + [DELTA]TL + PI + [LLP.sub.it] = [[alpha].sub.0] + [a.sub.1][ALLL.sub.it-1] + [[alpha].sub.2][NPL.sub.it-1] + [[alpha].sub.3][DELTA][NPL.sub.it] + [[alpha].sub.4][DELTA][TL.sub.it] + [[alpha].sub.5][Pl.sub.it] + [[epsilon].sub.it] Note: Adjusted R-Squared is 0.1133 and the t and p values are adjusted for heteroscedasticity. Data are taken from "Gall Reports" (reporting forms FFIEC: 031 and FFIEC 041), which are regulatory filing of U. S. conunercial banks. All (lata are publicly available. For more information on the Call Report see the Federal Financial Institutions Examination Council's (FFIEC) web site at fec.gov. All data are publicly available except those items related to the aging schedule of loans receivable (items RCFD1407 and RCFD1403). LLP: Loan loss provision expense (RIAD4230) scaled by beginning of the period total loans (RCFD2122). ALLL: Allowance for loan and lease losses (RCFD3123) scaled by beginning of the period loans (RCFD2122). NPL: Non-performing loans, which includes loans delinquent greater than 90 days (RCFD1407 + RCFD1403), scaled by beginning of the period loans (RCFD2122). [DELTA]NPL: Change in the value of non-performing loan since the prior period scaled by beginning of the period loans (see definition of NPI. Ratio). [DELTA]TL: Total loans at the end of the period (RCFD2122)--total loans at the beginning of the period scaled by total loans at the beginning of the period. PI Index: Prudence Indicator (see Table 1).