The Implications of Banks' Credit Risk Modeling for their Loan Loss Provision Timeliness and Loan Origination Procyclicality

We examine the implications of banks' credit risk modeling (CRM) for the timeliness of their loan loss provisions (LLP) and the procyclicality of their loan originations. We identify two distinct types of CRM from disclosures in banks' financial reports: (1) overall credit risk measurement modeling, typically statistical analysis of loan performance statuses and underwriting criteria (MODEL); and (2) stress testing of credit losses to possible adverse future events (STRESS). We expect these two CRM activities to have different implications, because MODEL is primarily historically focused whereas STRESS is primarily forward-looking. Statistical analysis of historical data places discipline on banks' loan loss reserving during stable economic times and for homogeneous loans, but is limited at sharp turns in economic cycles and for heterogeneous loans, when forward-looking CRM becomes essential. We predict and find that MODEL is associated with timelier LLPs on average across our 2001-2010 sample period and late in the financial crisis after banks had experienced heightened credit losses for a period of time, and that STRESS is associated with timelier LLPs early in the financial crisis. We argue that CRM enhances LLP timeliness because it yields informationally richer LLPs that are less sensitive to summary underwriting criteria. Consistent with this argument, we find that MODEL reduces the reliance of banks' LLPs on the loan-to-income ratio (estimated using disclosures required under the Home Mortgage Disclosure Act) for their homogeneous single-family mortgages. Following Beatty and Liao (2011), we expect banks with higher LLP timeliness to exhibit lower loan origination procyclicality. We find that MODEL is associated with less procyclical loan originations, particularly for homogeneous loans, and that STRESS is associated with less procyclical originations of heterogeneous loans.