Policy Uncertainty and Loan Loss Provisions in the Banking Industry

Abstract

Policy uncertainty is an increasingly important issue facing many economies. In this paper, we examine how banks accrue for loan losses in response to policy uncertainty (PU) and the implications of these accruals in terms of actual loan losses and future liquidity creation. Consistent with banks recognizing more loan losses in anticipation of PU’s depressive effects, we document a contemporaneous positive association between PU and loan loss accruals. This positive association is more pronounced for banks with a riskier loan portfolio and that have a history of lower loan loss reserves. We also find that banks making more loan loss provisions in times of higher PU have significantly higher future loan charge-offs and lower future liquidity creation. Overall, our paper highlights that PU affects the loan loss accruals of banks and that these accruals reflect rational expectations about PU’s depressive effects on the economy.