DP14803 Switching From Incurred to Expected Loan Loss Provisioning: Early Evidence

Author(s): Germán López-Espinosa, Gaizka Ormazabal, Yuki Sakasai
Publication Date: May 2020
Keyword(s): bank accounting, expected credit losses, loan loss provision
JEL(s): G21, M41
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14803

This paper provides early evidence on the effect of global regulation mandating a switch from loan loss provisioning (LLP) based on incurred credit losses (ICL) to LLP based on expected credit losses (ECL). Using a sample of systemically important banks from 74 countries, we find that ECL provisions are more predictive of future bank risk than ICL provisions. To corroborate that the switch to ECL provisioning results in more information to assess bank risk, we analyze the market reaction to disclosures on the first-time impact of the accounting change; we find that a higher impact on loan loss allowances elicits lower stock returns, higher changes in CDS spreads, and higher changes in bid-ask spreads. Critically, these patterns are most pronounced when credit conditions deteriorate. Finally, we also find evidence that, as credit conditions worsen, the rule change induces an increase in provisions and a contraction of credit. Our study contributes to the debate on the effect of the ECL model on procyclicality, an especially pressing issue in the context of the current pandemic.