Loan Loss Reserves, Regulatory Capital, and Bank Failures: Evidence from the 2008-2009 Economic Crisis

This paper tests the influence of regulatory capital guidelines on the link between banks’ loan loss reserve decisions in 2007 and the risk of bank failure during the 2008-2009 economic crisis. Our primary finding is that larger loan loss reserve increases in 2007 are associated with an increased risk of bank failure in 2008-2009, but only for banks that are allowed to add back loan loss reserves as Tier 2 capital. The results suggest that the ability to add back loan loss reserves to regulatory capital creates the illusion of non-declining financial health, which allows banks to avoid taking the actions necessary to reduce failure risk. Our results thus challenge the notion that the buffer created by loan loss reserves lowers bank failure risk. Simultaneously they question the soundness of recent regulatory proposals to allow even more loan loss reserves to be added back in the calculation of regulatory capital.