ACCOUNTING WORKSHOP “Using Loan Loss Indicators by Loan Type to Sharpen the Evaluation of the Determinants and Implications of Banks’ Loan Loss Accruals”

We show that the determinants and economic implications of the primary loan loss indicators reported in financial reports—non-performing loans (NPL), the allowance and provision for loan losses (ALL and PLL), and net loan charge-offs (NLCO)—vary dramatically across real estate, commercial, and consumer loan types, because these 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. This analysis indicates that banks’ exercise of discretion over PLL is largely limited to heterogeneous commercial loans, a small slice of banks’ loan portfolios. It also provides many insights into the bank-specific and macroeconomic drivers of banks’ loan loss accruals. We conduct two analyses that illustrate the increased statistical power and construct validity that results from conducting research on the implications of banks’ loan loss accruals by loan type. First, we show that this approach improves the accuracy of outof-sample predictions of future NLCO, more so for samples of banks that exhibit greater variation in loan portfolio composition from that of the average bank. Second, we show that this approach substantially strengthens Beatty and Liao’s (2011) finding that banks that record more timely PLL exhibit lower loan origination procyclicality. While we hand collect banks’ ALL by loan type from their financial reports, researchers will not have to incur this sizable cost going forward as bank regulatory filings contain this information beginning in 2013. Our results illustrate the usefulness of these disaggregated disclosures for future accounting research. JEL: G21, G28, M41, M48