Larry D. Wall and Timothy W. Koch
Economic Review, Vol. 85, No. 2, 2000
The philosophy underlying a bank's accounting for loan losses might have a material effect on the net income the firm reports to investors, which is a concern for securities regulators. A bank's loan-loss accounting philosophy might also significantly affect its ability to absorb unexpected future losses, which is a concern for bank supervisors. For example, a bank that follows a conservative loan-loss philosophy (maintains a higher loan-loss allowance) may be better able to absorb unexpected losses but also may have more freedom to manage reported earnings. This article focuses on the extent to which securities regulators and bank supervisors should be concerned about banks' accounting.
The authors' conclusion is that neither the bank supervisors' nor the securities regulators' concern is as serious as it may seem at first glance. Using currently available data, investors can and do form estimates of the "economically true" amount of banks' loan-loss allowances, provisions, net income, and equity capital. Strict adherence to Securities and Exchange Commission guidelines may improve the quality of the data, but the guidelines may not eliminate the benefit or reduce the cost of investors' making their own estimates. However, bank supervisors have the authority to require banks to hold additional equity capital if the bank's loan-loss allowance is judged inadequate to absorb future losses.