The Information Effect of Bank Loan Loss Provisions

Abstract

The analysis of financial reporting of banks is of great interest for risk assessment and for understanding potential of increase in market value. Following the quantitative decomposition of bank reserves size on bad debts, the article concludes about the existence of "subjective component" that acts as a qualitative signal for market investors. The paper analyses information significance for market investors of a number of indicators of financial reporting of 989 commercial public banks associated with credit risk. The paper is focused on considering of three financial statement items: non-performing loans, loan charge-offs, loan loss provisions.

The study provides for the analysis of statistical data on the Russian market and the results of the empirical research on the global bank market with sub-samples on developed and emerging markets, banks of the Eastern Europe and the CIS. The analysis scale is from 2011 to 2015, quarterly observations. It is shown that the share of non-performing loans, loan loss provisions and loan charge-offs can be informative for market investors not only in risk assessment of a bank, but also in diagnosing of management behavior, of expectations on valuation of a public bank (market capitalization). The emphasis in the paper is placed on loan loss provisions, as this item is highly exposed to manipulations from bank managers, according to previously made researches. In the study, the attempt is made on a large sample of banks of the global market to empirically distinguish "objective" and 'subjective" components on the item of loan loss provisions in financial reporting. Quantitatively evaluated is the influence of "subjective" element of reservation on market value of a public bank. Moreover, revealed are the reasons of detected positive influence of overstatement of established reserves on market capitalization of a bank, despite the decrease of its current profit measure. Positive correlation can be explained by the impact of signal effects from bank management towards market investors regarding future sustainability of a bank.