The Effects of Credit Competition on Banks’ Loan Loss Provision Timeliness: A Natural Experiment Across Contiguous State Borders

Posted by D. Daniel Sokol

Yiwei Dou, New York University (NYU) - Department of Accounting, Taxation & Business Law, Stephen G. Ryan, New York University (NYU) - Leonard N. Stern School of Business and Youli Zou, University of Toronto - Rotman School of Management have a paper on The Effects of Credit Competition on Banks’ Loan Loss Provision Timeliness: A Natural Experiment Across Contiguous State Borders.

ABSTRACT: Prior research has documented specific benefits, but not costs, of timelier loan loss provisioning for reporting banks and the overall financial system. We examine one such cost in this paper. We argue that potential entrants into a local loan origination market use incumbent banks’ reported loan loss provisions to assess incumbents’ loan underwriting quality and thus the desirability of market entry. By loan underwriting quality, we mean banks’ ability to evaluate credit risk to determine which loans to grant as well as the interest rates and other contractual terms of granted loans. Incumbents with better loan underwriting quality leave fewer profitable lending opportunities for potential entrants. We use variation in interstate branching deregulation across states from 1994 to 2005 as a natural experiment to investigate how increased threat of entry affects incumbent banks’ loan loss provision timeliness. We predict and find that incumbents more subject to entry reduce the timeliness of their bad news (but not good news) loan loss provisions to increase their perceived loan underwriting quality. Further, we predict and find variation in this behavior across loan origination markets attributable to incumbents’ loan portfolio composition and borrower turnover in those markets.