Disciplining Banks for the Next Economic Downturn

This summer marks 10 years since the end of the Great Recession, which saw the loss of more than eight million American jobs and was the catalyst for regulatory reforms such as the Dodd-Frank Wall Street Reform and Consumer Protection Act.

According to Sehwa Kim, assistant professor of accounting, the aftermath of the recession also inspired changes to both the practice and academic study of accounting.

“After the recession, the role of accounting has been heavily discussed among regulators, banks, and academics,” Kim says. “It’s more like the role of financial reporting, in terms of financial stability and economic cycles.”

Kim’s view of the contemporary role of accounting informs the research in his new working paper, “Do Delays in Banks’ Loan Loss Provisioning Affect Economic Downturns? Evidence from the U.S. Housing Market.”

The paper examines the effect that loan loss provisions — an expense banks set aside in case a loan defaults — had on risk-taking in the American mortgage markets, the price of homes, and household consumption during the recession.

“Loan loss provisioning has gained great attention,” Kim says. “If you look at a bank’s balance sheet, it is one of the largest core items in bank accounting.”

Kim says the motivation behind the paper involved the role that bank managers, auditors, and regulators played in the timing of loan loss provisions during the financial crisis.

“If the banks are more disciplined and recognize this loan loss provision in a timelier manner, they can endure better during an economic crisis,” Kim says.

To demonstrate the negative effect of delayed loan loss provisions on house prices, Kim created two theoretical mechanisms — “the credit crunch channel” and the “distressed sales channel.”

If the banks are more disciplined and recognize this loan loss provision in a timelier manner, they can endure better during an economic crisis

In the former, Kim says that if banks delay loan loss provisioning when the housing market is stable, they might carry loan loss overhangs and could enter a crisis period without recognizing it. According to the research, during a crisis, banks face increased pressure in terms of their capital concerns, which decrease the incentive to issue new mortgages.

“Eventually, there is a negative relation between mortgage supply and house prices,” Kim says. “If banks reduce their mortgage supply during the crisis because they are concerned their loan loss provisioning is delayed, it has a negative impact.”

Kim’s second mechanism, “distressed sales channel,” means that some banks would delay their loan loss provision, take on extra risk in a healthy economy, and lend to risky borrowers, which led to foreclosures during the crisis.

“Foreclosure means that there is a down pressure on housing prices,” Kim says. “That’s why I think that this additional risk-taking led to more foreclosure during the crisis and eventually had a negative impact on the housing market.”

Using these frameworks, Kim demonstrates how delays in loan loss provisions affected the housing market on what he calls a “ZIP code level” both in a period of economic stability and during a time of crisis. Kim says the decline of housing prices during the recession led to decreases in household consumption.

“If banks keep delaying loan loss provisions, it has an impact from the consumer’s perspective,” Kim says. “It has implications for their welfare during a recession.”

As for the future of the relationship between the housing market and loan loss provisions, Kim says the US Treasury Department’s move to a new loan loss policy, the Current Expected Credit Loss Model, implies that the new standard may affect economic downturns via the household channel, to the extent that it will discipline banks with respect to their loan loss provisioning.

“My study suggests that if this new policy better disciplines banks loan loss provisioning, then banks are less likely to delay,” Kim says. “When we have a similar type of housing crisis, it is going to mitigate the negative effect on the economy.”