Bank loan loss provisions and capital management under the basel accord

BANK LOAN LOSS PROVISIONS AND CAPITAL MANAGEMENT UNDER THE BASEL ACCORD ZHOU YUNXIA (B.Econ. University of International Business and Economics) A THESIS SUBMITTED FOR THE DEGREE OF DOCTOR OF PHILOSOPHY DEPARTMENT OF FINANCE AND ACCOUNTING BUSINESS SCHOOL NATIONAL UNIVERSITY OF SINGAPORE 2007 ACKNOWLEGEMENTS First and foremost, I would like to express my wholehearted gratitude to my supervisor, Associate Professor Michael Shih, for his professional guidance and support of my research endeavor throughout the five years of Ph.D study at the National University of Singapore. The experience of working with Professor Michael is a rigorous learning process. The training I received with regard to research and teaching has been the best possible start I could ever have had in my academic career. This thesis would not have been possible without his active support and valuable comments. I also would like to express my special thanks to my dissertation committee members: Assistant professor Anand Srinivasan and Assistant professor Keung Ching Tung. They have provided insightful comments and suggestions during my thesis time as well as on the preliminary version of this thesis. My dissertation also benefits from the constructive feedback from participants of NUS seminars and workshops. I am grateful to the Department of Finance and Accounting for granting me the research scholarship and providing the database. I am also deeply indebted to Professor Allaudeen Hammed, Senior Lecturer Cheng Chee Kiong, Assistant Professor Li Nan, Associate Professor Srinivasan Sankaraguruswamy, Associate Professor Trevor Wilkins, for their great encouragement and guidance on my research and teaching. Also, I have pleasure to study and work with my entire peer Ph.D friends. I thank them very much for their input in my research work and good companionship. i Finally, and foremost, I would like to thank my parents for their unfailing support and encouragement over all these years. They have always been there supporting my efforts in pursuing Ph.D. degree. For their endless love and support, I dedicate my dissertation to them. ii TABLE OF CONTENTS ACKNOWLEGEMENTS .i TABLE OF CONTENT . iii SUMMARY .v LIST OF TABLES vi LIST OF ILLUSTRATONS viii CHAPTERS PAGES 1. INTRODUCTION 2. LITERATURE REVIEW .9 2.1. Capital management and regulatory requirements 2.2. Capital management via loan loss provisions 13 2.3. Capital management vs. risk management 18 2.4. Nonaudit service research review 20 3. HYPOTHESIS DEVELOPMENT 355 3.1. Capital management 35 3.2. Earnings management 39 3.3. Level of nonaudit service fees .42 3.4. Variability of nonaudit service fees .44 3.5. Size effect 47 4. RESEARCH DESIGN AND SAMPLE SELECTION .51 4.1. Regulatory capital and earnings variables .51 4.2. Firm-specific characteristics variables .54 4.3. Estimation of discretionary loan loss provisions .55 4.4. Sample and descriptive statistics .56 iii 5. MAIN RESULTS 68 5.1. Evidence on capital management 68 5.2. Conflicts between earnings and Tier II capital … .71 5.3. Evidence on nonaudit services .72 5.4. Evidence on size effect 75 5.4. Evidence on interactions between three bank-specific characteristics…………………………………… 76 6. SENSTIVITY ANALAYSIS 88 6.1. Total loan loss provision 88 6.2. Regulatory capital requirements and FDIC……………………… 92 6.3. Adequately-capitalized banks and well-capitalized banks .……….95 7. CONCLUSION .105 BIBLIOGRAPHY 110 APPENDIX 118 iv SUMMARY This thesis empirically examines capital management mechanisms of the U.S. banks under the Basel capital adequacy accord. An important finding is that Tier I capital (primary capital under the regulatory regime prior to the Basel accord) and Tier II capital management incentives and their associated manipulation mechanisms are significantly different. Banks are likely to decrease (instead of increasing) loan loss provisions for Tier I capital management. In contrast, banks increase loan loss provisions for Tier II capital management. This dichotomy in capital management via loan loss provisions is completely missed out in prior literature. The conflicting effects of loan loss provisions on Tier II capital and earnings are also studied. Results suggest that, among banks with the same level of Tier II capitals, banks would prefer to decrease loan loss provisions for earnings management purpose if there is an earnings decrease from the previous year. This study further examines cross-sectional variations of identified capital management mechanisms across banks with three different firm-specific characteristics - nonaudit service fee ratios, variability of the ratios, and bank size. Consistent with evidences from non-banking industries, high level of nonaudit service fees strengthens the association between regulatory capital and loan loss provisions. In other words, banks purchased substantial amount of nonaudit services are likely to engage in capital manipulations. Another appealing finding is that, in contrast to the “economic bond” theory, consistent and regular purchases of nonaudit services (low variability) suppress manipulation actions. Lastly, capital management prevails in small banks. These findings not only enrich capital management literature, but also have important regulatory implications. v LIST OF TABLES TABLE PAGE 2.1 U.S.Five-Grade Loan Classification System…………………………… 26 2.2 Nonaudit Services Research Review…………………………………… 27 2.3 Summary of Earnings Quality Measures in Prior Nonaudit Service Studies………………………………………… 28 4.1 Sample Descriptive Statistics………………………………………………. 61 4.2 Descriptive Statistics of Auditor Fees of Banking Holdings Companies (2001-2005)………………………………………………… 63 4.3 Descriptive Statistics of Fees Disclosed by Big and non-Big Auditors …………………………… 64 4.4 Time-Series Analysis of Audit and Nonaudit Fees and Ratios…………………………………………… . 65 5.1 Capital Management Hypothesis Test (Dependent Variable= DLLP, N=1, 609)………………………………… . 79 5.2 Impact of Nonaudit Service Fee Level on Capital Management Mechanisms………………………………………………… 81 5.3 Impact of Nonaudit Service Fee Variability on Capital Management Mechanisms……………………………………… . 82 5.4 Effect of Size on Banks’ Capital Management Mechanisms ……………… 84 5.5 Interaction between HNAF and VAR on Banks’ Manipulation incentives (Dependent Variable= DLLP) …………………………………………… . 85 5.6 Interaction between HNAF and SIZE on Banks’ Manipulation Incentives (Dependent Variable= DLLP)……………………………………………… 87 6.1 Sensitivity Test of Capital Management Hypothesis (Dependent Variable= LLP)………………………………………………… 97 vi 6.2 Sensitivity Test of HNAF impact on Capital Management Mechanisms……………………………………………… 6.3 Sensitivity Test of VAR impact on Capital Management Mechanisms ……………………………………………………………… . 100 6.4 Sensitivity test of Size Effect on Banks’ Capital Management Mechanisms…………………………………………………………… 102 6.5 Sensitivity Test of the Interaction between HNAF and VAR on Banks’ Manipulation Incentives …………………………………………………… 103 6.6 Sensitivity Test of the Interaction between HNAF and SIZE on Banks’ Manipulation Incentives …………………………………………………… 104 vii 99 LIST OF ILLUSTRATONS ILLUSTRATION PAGE 2.1. How to Calculate Capital Adequacy Ratios…………………………… 29 2.2 Effect of Loan Loss Provisions on Tier I Capital and Tier II Capital under the Basel Adequacy Accord…………………………………… . 33 3.1 The SEC rule (2000) and Audit Services Pre-approval Policy…………………………….…………………… 49 4.1 Regulatory Capital Adjustment………………………………………… 66 viii CHAPTER INTRODUCTION Although capital management has been extensively documented in prior research, there is no direct evidence of bank managers’ adjustment to the regulatory capital requirement changes in the Basel Accord. Past papers either focus on banks’ discretionary behaviors on primary capital prior to the Basel Accord (Greenawalt and Sinkey, 1988; Moyer, 1990; Scholes, Wilson and Wolfson, 1990; Wahlen, 1994; Wetmore and Brick, 1994; Beatty, Chamberlain and Magliolo, 1995), or focus on the marginal transition effect of different capital regulations before and after the implementation of the Basel Accord (Kim and Kross, 1998; Ahmed, Takeda, and Thomas, 1999). This thesis directly examines the U.S. banks’ capital management mechanisms associated with both types of regulatory capital - Tier I capital and Tier II capital under the Basel Accord regime. I also extend prior research by investigating cross-sectional variations of capital management mechanisms, aiming to identify the impact of some firm-specific characteristics on capital management incentives. Capital management mechanisms via loan loss provisions have been significantly changed since the Basel Accord in 19911. Prior to that, banks must have primary capital ratio exceeding 5.5% to be adequately capitalized. Because the net effect of loan loss provisions on primary capital is the tax shield of loan loss provisions, banks with low primary capital are likely to manipulate regulatory capital upward via increasing loan loss provisions. This positive impact of loan loss The capital-raising target could also be reached via security gains and losses, loan charge-offs, capital notes, common stock, preferred stock, and dividends. TABLE 6.6 Sensitivity Test of the Interaction between HNAF and SIZE on Banks’ Manipulation Incentives (Dependent variable= LLP) Independent Variable Coefficient Estimates Two Tailed p-value (Constant) -0.0129 0.00 TIC T2C T2C*DECRE LLR EBTP DECRE TIC*HNAF T2C*HNAF LLR*HNAF EBTP*HNAF DECRE*HNAF TIC*HNAF*SIZE T2C*HNAF*SIZE LLR*HNAF*SIZE EBTP*HNAF*SIZE DECRE*HNAF*SIZE BIGFIVE 0.0003 -0.0001 0.5855 -0.0138 0.0000 -0.0003 0.0002 -0.0003 0.0071 0.0004 0.0009 0.0001 -0.0006 -0.0118 -0.0004 -0.0008 -0.0007 0.01 0.03 0.03 0.01 0.88 0.28 0.04 0.07 0.22 0.11 0.09 0.25 0.03 0.11 0.14 0.21 0.00 LEVERAGE 0.0000 0.97 ∆NPL 0.0990 0.00 LASSET LLR LOANR LOANC LOAND LOANA LOANI LOANF 0.0003 0.3631 0.0046 0.0096 0.0046 0.0048 0.0201 0.1485 0.00 0.00 0.02 0.00 0.57 0.21 0.00 0.15 R-square Adjusted R-square 40.07% 39.05% 104 CHAPTER CONCLUSION This thesis empirically investigates the U.S banks’ capital management mechanisms under the Basel Accord. To provide deeper and more specific evidences on bank managers’ responses to new capital requirements, this thesis also examines the cross-sectional variations of capital management mechanisms across banks of different firm-specific characteristics. Specifically, three firm-specific characteristic factors are considered in this study- bank size, magnitude and variability of nonaudit service fees. Two types of regulatory capital - Tier I capital and Tier II capital, are examined together for the first time in this thesis. It is important to note that under the Basel Accord, in addition to Tier I capital, Tier II capital also has substantial impact on capital management incentives Moreover, the capital management mechanisms of Tier I capital and Tier II capital are extraordinarily different. However, this dichotomy is completely missed in the literature. The capital managements of Tier I capital and Tier II capital via loan loss provisions are both examined in this thesis. The results reveal that, specifically: (I) Tier I capital is positively related to loan loss provisions. This finding is different from literature results. Prior papers document negative association between primary capital and loan loss provisions. Because loan loss reserves are removed from Tier I capital under the Basel Accord, and the net effect of loan loss provisions on Tier I capital becomes negative. Thus banks would like to manipulate Tier I capital r upward by decreasing loan loss provisions, instead of increasing as they did prior to the Basel Accord. (II) In contrast to Tier I capital management 105 mechanism, Tier II capital is negatively associated with loan loss provisions. This suggests that banks would choose to increase loan loss provisions to inflate Tier II capital. (III) Because the loan loss reserves includable in Tier II capital are limited to an upper bound, banks with less loan loss reserves generally have higher Tier II capital manipulation incentives. (IV) Loan loss provisions have conflicting impact on Tier II capital and earnings which is caused by the new capital requirement changes under the Basel Accord. I find out that, among banks with the same level of Tier II capital, banks with earnings decrease from the prior year would choose to decrease loan loss provisions for earnings management purpose, instead of increasing loan loss provisions to boost up Tier II capital. Moreover, unlike the contradictory effects related to Tier II capital and earnings, manipulation incentives of Tier I capital and earnings become consistent under the Basel Accord. Banks are able to increase Tier I capital and earnings at the same time via loan loss provision reduction. Regulators need to pay more attention to this new relationship. The alignment between Tier I capital and earnings may encourage banks to involve in capital management or earnings management actions or both. Bank managers can now manage to increase either capital or earnings without worrying about the decrease of the other as they did prior to the Basel Accord. Extending the research scope of prior capital management studies, this thesis further analyzes the cross-sectional variations of the above identified capital manipulation mechanisms as a function of three firm-specific characteristics factors. It is for the first time in literature that this paper answers the research question how capital manipulation mechanisms change dynamically across different banks. My results show that: (I) in comparison with large banks, capital managements via loan loss provisions prevail in small banks. (II) Consistent with evidence from non-banking industries, high level of nonaudit 106 services purchased from incumbent auditors strengthen the association between bank capital and loan loss provisions. In other words, banks that purchase nonaudit services in large amount are more likely to engage in capital management behaviors. (III) In contrast, nonaudit service purchases of low variability weaken the tie between loan loss provisions and regulatory capital, suggesting that regular and consistent nonaudit service purchases suppress banks’ discretionary incentives. (IV) This thesis also examines the impact of the interaction between nonaudit service fee magnitude and purchase frequency. My results indicate that nonaudit service fee magnitude plays a dominant role when banks’ nonaudit service purchase frequencies are the same. Among banks with the same nonaudit service purchase pattern, banks with high level of nonaudit service fees are more likely to participate in capital management actions. The capital manipulation mechanisms and their cross-sectional variations identified in this thesis paper uncover “crimes” possibly conducted by bank managers in response to regulatory changes of the Basel Accord. Based on the results, I can suggest governance practitioners and academics to take a more circumspect regulatory policy approach to detect manipulative behaviors, and take appropriate “punishment” to fit “the crime”. Furthermore, my findings can provide valuable reference to regulatory institutions and researchers even if the Basel II is implemented in the United States22. Basel II aims to improve the internal risk measurement system by providing a more forward-looking approach, however, the regulatory capital compositions and calculation methods are left unchanged. My findings might also be of interest to auditors. Audit risk and related legal liabilities can be affected by regulatory changes. Understanding banks’ capital management incentives and mechanisms can help auditors to lower unnecessary audit risk exposure. 22 The United States is still having the national regulator implementation of the Basel Accord, but not Basel II. 107 There are several limitations and caveats to this study. First, although this thesis examines nonaudit service as one firm-specific characteristic factor when investigating the crosssectional variations of capital management mechanisms, it does not discuss whether auditor independence is truly impaired or not. This stand-alone marginal analysis can not tell much about that due to the unobservability of auditor independence. Advanced and rigorous models which can probe subjective issues are needed. Thus this study only uncovers the impact of nonaudit services on the association between banks’ regulatory capital and loan loss provisions. Second, the impact of nonaudit service purchase variability on capital management should be considered in light of my sample selection process. It is possible that purchasing nonaudit services in a consistent and regular manner suppresses banks’ managerial actions only for the sample period 2000-2005 when nonaudit services attract the highest regulatory attention ever. Third, limited sample size and time period prohibit the results to be generalized to other samples and other time periods. However, the limitation in sample period is necessary because the nonaudit service fee data becomes available only starting from year 2000. Finally, my evidence of capital management mechanisms are industry-specific, which have difficulties to be generalized to other non-banking industries. Going forward, I expect that bank capital managements via loan loss provisions will continue to be the main object of interest in accounting research. There has been recently intense discussion on Basel II which aims to better align bank capital with actual risks facing by banks. In addition to the Basel II amendment that incorporated market risks in 1996, Basel committee issued an agreed text and a comprehensive version of Basel II Framework in June 2004 and July 2006 respectively. It is quite evident that this Basel II will not have much relevance if the bank capital quality is not satisfactory. This thesis uncovers the dynamics how bank capital quality is deteriorated by managerial actions and how it is changed across 108 different banks. Therefore, despite the limitations, the evidence of capital management mechanisms and their cross-sectional variations identified in this study have very important and relevant implication in the future even after the Basel II implementation. 109 BIBLIOGRAPHY Abbott, P., G. Peters, and D.V. Rama. 2003. Audit, Non-Audit and information technology fees: Some empirical evidence. 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The provisioning may range from 40% to 60% of the doubtful loan value under the provisioning reference system in mainland china. That is, even if managers consent to classify a loan as a doubtful loan, the real provisioning difference could be as big as 25% of the total doubtful loan value among different managers. I. Loan loss provision percentage reference (Hong Kong Monetary Authority (“HKMA”) Pass 1% Special mention 2% Substandard 20-25% Doubtful 50-75% or 75-100% (if classified as doubtful for > months) Loss 100% II. Loan loss provisioning method (China, Mainland) Type “Reference percentages” to each grade Based on quarter-end loan balances* General provision >= 1% 118 Specific provision Special mention 2% Substandard 25%, but may range from 20% to 30% Doubtful 50%, but may range from 40% to 60% Loss 100% Special provision According to special risk characteristics such as country risk and industry sector risk as assessed by the banks * Includes customer loans and loans to financial institutions Note: 1. General provisions: It is also known as collective provision. Focus is on the incurred losses that cannot yet be ascribed to individual loans. UK Statement of Recommended Accounting Practices (SORP): “…portfolios of advances often contain advances which are in fact impaired at the balance sheet date, but which will not be specifically identified until some time in the future…To cover the impaired advances which will only be identified as such in the future, a general provision should be made” 2. Specific provisions: Focus is on the procedure to arrive at a net book value of individual loans to establish specific allowances to cover ascertained and estimated losses in those loans on an item-by-item basis. UK Statement of Recommended Accounting Practices (SORP): “A loan is impaired when, based upon current information and events, the bank considers that the creditworthiness of the borrower has undergone deterioration such that it no longer expects to recover the advance in full” 3. The above data are from KPMG Regulatoryalert, Issue June 2002. 119 [...]... gains, loan loss provisions and equity Among those, loan loss provision account is the most popular capital management tool identified in literature Moyer (1990) and Scholes, Wilson, and Wolfson (1990) examine the capital management via loan loss provisions and other tools They found out that banks with capital levels close to violating minimum capital requirement inflate capital via loan loss provisions. .. important capital management mechanisms in response to the new capital requirements under the Basel Accord Firstly, I find a positive association between Tier I capital and loan loss provisions Bank managers are likely to reduce loan loss provisions (instead of increasing loan loss provisions as they did before the Basel Accord) to preserve Tier I capital This finding is different from Moyer (1990) and 2... introduction on the association between capital management and regulatory capital requirements in section 2.1 Section 2.2 explains the rationale of choosing the loan loss provision account as a capital management tool and the associated capital management mechanism The applicability of capital management under the Basel Accord regime (even the Basel II regime) is demonstrated in section 2.3, followed by the literature... accessible and/ or expensive to be obtained, outside investors and regulators can hardly verify the validity of the managers’ judgments on loan loss provisions Despite capital management, bank management may have some other objectives to reach via loan loss provisions There are two other streams of studies on the manipulation of bank loan loss provisions for purposes other than capital regulatory ratios The. .. excess of 5.5% and total capital ratio over 6% of its standardized total assets The Basel Committee on Banking Supervision (BCBS) introduced a new capital measurement system for the international convergence on capital measures and capital standards in 1988, which is commonly known as the Basel Capital Accord (hereafter, the Basel Accord) The United States started to implement the Basel Accord through... Although they show some under- provisioning of loan loss provisions in the new Basel regime comparing to periods before 1991, the relationship between loan loss provisions and Tier I capital in these two papers are negative To extend the research scope of prior related studies, for the first time in literature I also examine the differences of the relation between loan loss provisions and regulatory capital. .. both the mean (8.26 %) and median (5.99 %) of the ratio of loan loss provisions to primary capital are the highest comparing to all other capital management tools tested in that paper This is not surprising Loan portfolios are the most important assets in banking industry which are typically 10-15 times larger than equity, and loan loss provisions 5 Loan loss provisions are also referred to as loan- loss. .. to the market investors on the banks’ economic value Second, bank loan loss provisions are highly sensitive to capital management incentives Loan loss provisions are closely related to regulatory capital through loan loss reserves6 (contra-asset account) Every one dollar increase of loan loss provisions technically increases loan loss reserves by the same magnitude In both regimes before and after the. .. provisioning Bank managers’ first challenge is to segment the loan portfolio into different loan categories with similar characteristics Loan loss provisions are related to loan loss reserves, LLRT = LLPT −1 + LLPT − LWOT , one unit increase of loan loss provisions increase loan loss reserves by one unit 6 14 Then they have to estimate the loan loss and to determine the correspondent loan loss provision... contributes to studies on capital management and loan loss provisions in several ways First, my results have important regulatory implications It uncovers a complete series of capital management mechanisms related to the Basel Accord regulation These findings provide us a clear picture of how bank managers react to the capital regulations under the Basel Accord, and how they change their capital strategies . the composition and computation of regulatory capital. Prior to the implementation of the Basel Accord, total capital was the sum of primary capital and secondary capital. Under the Basel Accord, . related to the Basel Accord regulation. These findings provide us a clear picture of how bank managers react to the capital regulations under the Basel Accord, and how they change their capital. convergence on capital measures and capital standards in 1988, which is commonly known as the Basel Capital Accord (hereafter, the Basel Accord) . The United States started to implement the Basel Accord