The nature of information in commercial bank loan loss disclosures.

Abstract

Bank financial statements provide three separate disclosures of changing loan portfolio default risks: changes in non-performing loans, loan loss provisions and loan chargeoffs. The objectives of this study are to analyze the information in each of these loan loss disclosures about future cash flows and to examine how investors impound this information in bank stock prices. Accounting for loan loss provisions involves management discretion. Changes in non-performing loans and loan chargeoffs, as less discretionary measures of loan default risks, may enable investors to estimate management's use of discretion over reported loan loss provisions. If so, then an interesting question arises: what do discretionary provisions reveal? The results suggest that bank managers increase discretionary components of loan loss provisions when future cash flow prospects improve. Unexpected provisions are positively related to changes in cash flows through three years into the future. Also, bank stock returns indicate that investors interpret unexpected provisions as "good news" about future cash flows. Unexpected changes in non-performing loans and unexpected chargeoffs are important pieces of "bad news" about loan losses. These two disclosures are negatively related to future changes in cash flows and current period stock returns. Stock prices react positively to the release of unexpected provisions and negatively to the release of unexpected changes in non-performing loans and unexpected chargeoffs around earnings announcement dates and financial statement release dates. The observed reactions are not very robust, however. They are most pronounced when at least one of the unexpected loan loss disclosures is unusual. Changes in non-performing loans and chargeoffs are important pieces of information to use in interpreting the discretionary components of provisions. The relations between provisions and both returns and future cash flows are positive only when changes in non-performing loans and chargeoffs are included in the analysis. This study provides evidence on managers' use of discretion over financial reporting choices, and demonstrates a context in which the market infers valuation implications from discretionary reporting choices of managers. The results also provide a context in which the market's interpretation of a disclosure on the income statement is conditioned on related balance sheet and footnote disclosures.