Bank accounting conservatism and bank loan quality

Abstract

This study examines the effect of conservatism on bank’s own monitoring effort reflected in its loan portfolio quality. While prior research shows that timely recognition of expected loan losses reduces managerial risk taking through enhanced market discipline, few are the studies that investigate the implication of asymmetric timeliness of losses, otherwise known as conservatism, on bank risk taking or a bank’s own monitoring effort. Building on the premise that the monitoring benefit of conservatism in reducing bank’s risk-taking translates into better loan portfolio quality, this study documents that in a sample of publicly traded bank holding companies in the United States over the period 1994–2014, bank's conservatism is positively associated with loan quality. I also find that the effect of conservatism on loan quality is more pronounced for banks with high ex-ante information asymmetry or distress risk and during the low and high lending growth cycles when loan quality is likely to deteriorate. These findings should be of interest to regulators and policymakers who debate ways to incentivize banks to use their discretion inherent in loan loss provisioning in ways that is more informative and less opportunistic.