Journal of Accounting and Economics: Paul J. Beck, Ganapathi S. Narayanamoorthy

Journal of Accounting and Economics 56 (2013) 42–65
Contents lists available at ScienceDirect
Journal of Accounting and Economics

journal homepage: www.elsevier.com/locate/jae
Did the SEC impact banks' loan loss reserve policies

and their informativeness?$
Paul J. Beck 1, Ganapathi S. Narayanamoorthy n
University of Illinois at Urbana- Champaign, College of Business, 284 Wohlers Hall, MC-706, 1206 S. Sixth Street, Champaign, IL 61820, USA
a r t i c l e in f o abstract
Available online 17 July 2013 During the late 1990s, the SEC alleged that banks were overstating loan loss allowances
JEL classifications: to establish cookie jar reserves. Their intervention in bank accounting culminated in 2001
G14 with new guidance (SAB 102) designed to improve financial reporting quality. We show
G21 that banks' allowance estimation changed in response to the SEC's interven-
M41 tion. While allowance informativeness (as proxied by the ability to explain future losses)
improved for Strong Banks, informativeness declined for Weak Banks whose incentives
Keywords: are to understate allowances. Our results help to explain why some (Weak) banks delayed
Loan loss allowances loss recognition during the recent financial crisis.
Provisions & 2013 Elsevier B.V. All rights reserved.
Bank accounting
Smoothing
SEC
Regulatory intervention
1. Introduction
During the mid to late 1990s, officials of the Securities and Exchange Commission (SEC) expressed the concern that some
banks were using loan loss allowances to create cookie jar reserves for the purpose of smoothing income over time (Sutton,
1997; Levitt, 1998; Wall and Koch, 2000). These public comments alleged that banks were making arbitrary increases
to their allowance accounts that were not consistent with recent loss history and that such activities reduced the
informativeness of accounting information. The public comments help to provide an understanding as to why the SEC
decided to intervene in bank regulation by launching a highly publicized investigation of SunTrust Bank, writing letters
to banks, and issuing Staff Accounting Bulletin (SAB) 102 in July of 2001 (SEC, 2001). The SEC also persuaded bank regulators
(Federal Financial Institutions Examination Council [FFIEC]) to issue contemporaneously a policy statement providing
identical guidance to banks in developing their loan loss estimates and implementing controls over the estimation process.
Commenting retrospectively on the SEC's role in loan loss accounting, Mr. Eugene Ludwig (2009), who served as
Comptroller of the Currency from 1993 to 1998 states that:
“The current set of problems with reserves began in the late 1990s, when the Securities and Exchange Commission and the
Financial Accounting Standards Board, the masters of generally accepting accounting principles compliance, gained the
☆
The authors gratefully acknowledge insightful discussions with Brian Kleinhanzl of KBW and Bill Saska of the FDIC. Discussions with S.P. Kothari considerably
helped organize and delineate the contributions of the study. The authors also appreciate the detailed comments received from Stephen Ryan (the reviewer and JAE
Conference discussant), Wayne Guay (editor), Rashad Abdel-khalik, Keith Czerney, Emre Kilic, Gerald Lobo, Kaye Newberry, Cathy Schrand, Jake Seckler, Theodore
Sougiannis, Jayanthi Sunder, Dushyant Vyas, William Wright, Trevor Wilkins and participants at the 2012 JAE Conference, 2011 AAA Meeting, University of Houston,
University of Illinois and National University of Singapore Research Forums. Po-Chang Chen and Hui Zhou rendered excellent timely research assistance.
n
Corresponding author. Tel.: +1 217 244 6707; fax: +1 217 244 0902.
E-mail addresses: p-beck2@illinois.edu (P.J. Beck), gnarayan@illinois.edu (G.S. Narayanamoorthy).
1
Tel.: +1 217 333 4563; fax: +1 217 244 0902.
0165-4101/$ - see front matter & 2013 Elsevier B.V. All rights reserved.
http://dx.doi.org/10.1016/j.jacceco.2013.06.002
P.J. Beck, G.S. Narayanamoorthy / Journal of Accounting and Economics 56 (2013) 42–65 43
upper hand over the banking regulators, the masters of safety-and-soundness compliance. The victors changed the rules
and enforcement standards that apply to loss allowances… The new rules ended the practice of setting reserve levels
primarily according to the bank's own judgment of future developments. Instead, bankers had to use mark-to-market-like
discipline, reserving only for losses that reflected demonstrable prior experience. Under these rules, banks must justify
reserve levels with carefully wrought mathematical models based on past experience, reflecting estimated inherent losses
either on specific credits or the whole loan portfolio. These accounting changes were meant to prevent banks from using
their discretion to create large reserves to smooth out their earnings.” (Emphasis added)
We hypothesize that the guidance provided by SAB 102 and the FFIEC (2001) Policy Statement, in particular, encouraged
banks to place greater emphasis on historical loss experience (charge-offs) and less emphasis on non-performing (non-
accrual) loans2. This hypothesis is consistent with Ludwig's (2009) comments that the SEC and FASB changed the standards
and rules for allowance estimation to emphasize demonstrable prior [loss] experience. Contemporaneous with these
regulatory changes, economic conditions and banks' loan portfolios also changed during the 1992–2008 time interval of
our study.3 We control for these potentially confounding changes by partitioning our data into six time periods, using a
differences-in-differences design, and by including covariates for economic conditions and loan portfolio composition. After
implementing these controls, we present evidence that banks' loan loss allowances exhibited a structural shift and became
more highly associated with past charge-offs and less associated with non-performing loans in periods after the SEC's
intervention that culminated with the issuance of SAB 102.
In addition to analyzing the overall impact of the SEC's intervention, we develop and test specific hypotheses regarding
cross-sectional effects. Consistent with our hypothesis that Large Banks were under greater pressure to comply with SAB
102 guidance, we find that their allowances became more sensitive to charge-offs than those of Small Banks. Prior research
by Liu and Ryan (1995, 2006), Moyer (1990), Kim and Kross (1998), and Kanagaretnam et al. (2004) has demonstrated that
banks' loan loss provisioning is sensitive to earnings management incentives that vary with bank financial strength. Since
we expect that SAB 102 guidance will interact with earnings management incentives, we also partition banks into Strong
and Weak groups using two alternative measures of bank strength—profit before loan loss provisions and capital ratios. Our
results indicate that the allowances of Strong Banks became more sensitive to charge-offs in response to SAB 102 guidance
than those of Weak Banks.
The previous studies by Beaver et al. (1989) and Liu and Ryan (1995, 2006) have argued that non-performing loans (NPL)
provide a more timely measure of loss than charge-offs. However, the book value of loans classified as NPL is a noisy
indicator of the future losses since the protection provided by collateral is not considered. As such, it is not clear a priori
whether increased reliance on past charge-offs will actually enhance allowance informativeness. We employ the forward
association between loan loss allowances and future charge-offs as our informativeness proxy. For Strong Banks, we find
that loan loss allowances better explain future charge-offs in periods after SAB 102. The improvement in informativeness for
Strong Banks is consistent with the SEC's contention (as well as the findings in Liu and Ryan (2006)) that Strong Banks were
smoothing earnings prior to the SEC's guidance. However, the SAB 102 guidance appears to have resulted in lower allowance
informativeness for the Weak Banks – particularly in the period just prior to the financial crisis.
We attribute SAB 102's divergent effects on Strong and Weak Banks to two factors. First, the ability of past charge-offs to
explain future charge-offs improves with the stability in the environment and operations. Since Strong Banks are likely to
operate in more stable environments than Weak Banks, we would expect their charge-offs to be more stable over time.4 As
such, allowances based on charge-offs will be better predictors of future charge-offs for the Strong Banks than for the Weak
Banks. Second, as argued by Ludwig (2009), an objective of the SEC's intervention was to prevent earnings management.
Given bank regulators' focus on allowance adequacy, the opportunities for Weak Banks to understate loss provisions and
allowances may be constrained. Thus, we hypothesize that the SEC's regulatory focus was directed primarily toward banks
suspected of engaging in allowance overstatement. To the extent that Strong Banks engaged in earnings management
activities as alleged by the SEC, the charge-off centric guidance in SAB 102 coupled with regulatory scrutiny from the SEC
would be expected to constrain the ability of Strong Banks to accelerate loss provisioning and inflate their allowances. Under
these assumptions, we would expect allowance informativeness to be enhanced for Strong Banks. However, Weak Banks are
more likely to have incentives to delay or reduce loss provisioning. Reliance on charge-offs (rather than a more timely loss
indicator like NPL) under the new SAB 102 guidance might allow Weak Banks to delay loss provisioning in periods where
charge-offs are increasing, thus, diminishing allowance informativeness.
2
While SAB 102 contains no expressed preference for charge-offs over NAL in making allowance estimates, it added controls requiring allowances to
be reconciled with charge-offs as a means of encouraging compliance with Financial Reporting Release No. 28 (FRR-28) and discouraging arbitrary changes
to the allowance. These controls help to explain why banks’ loan loss allowances became more dependent on charge-offs and less dependent on non-
accrual loans (NAL).
3
Liu and Ryan (2006, p. 428) present evidence of greater acceleration of loss provisioning among profitable banks that have high concentrations
of homogeneous loans. This result, when combined with changing loan compositions over time, suggests that it is important to control for earnings
management incentives and loan composition in our analysis of the effects of SAB 102. We appreciate the reviewer's comments in highlighting the
importance of controlling for loan composition.
4
In un-tabulated results, we find that the association between current and lagged earnings before provisions for the Strong Banks is approximately
triple the corresponding association for Weak Banks. These substantial differences are consistent with other studies in non-bank contexts. For example,
Connolly and Schwartz (1985) and Basu (1997) show higher mean reversion in earnings for firms in weak financial condition.
44 P.J. Beck, G.S. Narayanamoorthy / Journal of Accounting and Economics 56 (2013) 42–65
Given the importance of loan loss estimates for banks, numerous studies have examined the sensitivity of loan loss
allowances and provisions to earnings management incentives, tax incentives, and compliance with regulatory capital
requirements. However, this study is the first to analyze the effects of the SEC's regulatory intervention in the banking
industry and to document inter-temporal changes in allowance-charge-off associations. The publicly recognized objective of
SAB 102 was to promote a more disciplined and consistent loan loss methodology by requiring banks to provide enhanced
documentation to support their loan loss allowance estimates. However, our results suggest that the SEC's intervention and
SAB 102 guidance, in particular have had a greater influence on banks' loan loss estimates than has been previously
recognized. Beatty and Liao (2011) show that delays in loss recognition exacerbated pro-cyclical lending policies leading up
to the recent financial crisis. Their findings lend support to the concerns about the implications of delayed loan loss
recognition identified by former bank regulators (Dugan, 2009; Ludwig, 2009). Our finding that allowances became
more responsive to past charge-offs provides an explanation why loss provisioning became more delayed and allowance
associations with future losses declined for Weak Banks after the SEC's intervention. Our results also provide a possible
explanation for the FFIEC's decision to revise (effective December 2006) the 2001 Policy Statement.
The remaining sections of this paper are organized as follows. Section 2 provides background information about the
banking environment and provides conceptual support for the hypotheses presented in Section 3. In Section 4, we discuss
sample selection and present descriptive information about the variables. Empirical results are presented in Section 5.
Section 6 contains our conclusions and research implications.
2. Background
2.1. Loan portfolio risk metrics
In 1980, the Federal Financial Institutions Examination Council (FFIEC) issued the Uniform Credit Classification and
Account Management Policy (UCCAMP) requiring banks to classify retail loans based on risk and to report charge-offs and
delinquent loans privately to bank regulators. Since 1983, the SEC's Industry Guide (2013) has required banks to supplement
their financial statements with risk-based disclosures including NPL and charge-offs. Keeton and Morris (1987) contend that
charge-offs and NPL are the two most important risk metrics for evaluating loan portfolio risk and loan loss allowance
adequacy and recommend that the metrics be utilized concurrently.5
Both NPL classifications and charge-offs are based primarily on the length of time elapsing since borrowers stopped
making payments. The relative informativeness of charge-offs and NPL as risk metrics involves trade-offs between relevance
and reliability. Since shorter time periods are typically used in classifying loans as NPL relative to those used for writing-off
loans as uncollectible (i.e., recording charge-offs), NPL can be viewed as a more timely indicator of loan risk than charge-offs
(see Liu and Ryan, 1995, 2006). However, NPL is a noisy indicator of the future loss in that it represents the book value of
loans that are deemed to be at risk and, thus, fails to consider the offsetting loss protection provided by collateral.
2.2. Loan loss guidance before the SEC's intervention
During the mid to late 1980s, many banks experienced substantial loan losses from defaults (Liu and Ryan, 1995). Bank
regulators responded to this situation by issuing additional guidance (e.g., FFIEC, 1993 Policy Statement) to bank managers
and bank examiners regarding loan and lease losses and by increasing their scrutiny of banks' allowance adequacy. The 1993
FFIEC Policy Statement provides both quantitative benchmarks and guidance based on consideration of qualitative factors
(e.g., economic conditions, past loss rates, and lending policies) for bank managers and examiners to use when evaluating
the adequacy of allowances. We note the prominence of the charge-offs and NPL risk metrics in the FFIEC's quantitative
allowance guidelines: 50% for loan portfolios classified as doubtful, 15% for loan portfolios classified as sub-standard, and the
average net charge-off rate over the prior two years for all loans not included in the two preceding categories. After
presenting the quantitative guidelines, the 1993 Policy statement (p. 8) made it clear that these percentages were “neither
a floor nor a safe harbor” and that banks need to incorporate “an additional margin to reflect the imprecision inherent in
estimates of expected credit losses.” The FFIEC (1993) Policy Statement (p. 38) also addresses the issue of using historical
loss rates to estimate allowances for loan and lease losses (ALLL):
Although historical loss experience provides a reasonable starting point for the institution's analysis, historical losses,
or even recent trends in losses are not, by themselves, a sufficient basis to determine the appropriate level for the
ALLL. Management should also consider any factors that are likely to cause estimated credit losses associated with the
institution's current portfolio to differ from historical loss experience…
The Office of the Comptroller of the Currency's Handbook (1998) affirms the 1993 Policy Statement guidance regarding
reliance on historical loss rates:
5
The Comptroller's Handbook also provides guidance to bank examiners in evaluating the adequacy of allowances. Examiners are required to evaluate
several key ratios (that depend on charge-offs and NPL) in assessing the adequacy of loan loss allowances. Examples include: allowance to net charge-offs,
Allowance to total loans and allowance to non-accrual loans and leases.
Although historical loss experience provides a reasonable starting point for the bank's analysis, historical losses, or
even recent trends in losses, cannot be accepted without further analysis. Regardless of the methodology used, the
bank must adjust the historical loss percentage for each pool to reflect the impact of any current conditions on loss
recognition. The adjustment should reflect management's best estimate of the level of charge-offs that will be
recognized. (Emphasis added)
2.3. The SEC's intervention and response by bank regulators
As outlined earlier, bank regulators responded to the financial problems in the late 1980s by monitoring the adequacy of
loan loss allowances and capital to absorb charge-offs. A priori, such scrutiny would be expected to constrain the ability of
banks to understate their loan loss provisions and allowances. However, bank regulators did not have comparable incentives
to scrutinize loss provisions and allowances for overstatement. Given an asymmetric focus on allowance understatements
by bank regulators, it is understandable that the SEC became concerned that some banks were inflating their allowances
to create cookie jar reserves for smoothing income (see Levitt, 1998; Wall and Koch, 2000; Liu and Ryan, 2006). The SEC's
then Chief Accountant Michael Sutton (1997) stated, “We have received a number of inquiries, both domestically and
internationally, that suggest that allowances for loan losses reported by some US banks may be overstated.” Sutton's (1997)
statement is noteworthy as it presaged the SEC's highly publicized investigation of SunTrust Bank that culminated in a large
downward $100 million restatement of their loan loss allowance in 1998.
During the SunTrust investigation, the SEC also sent letters to several banks questioning their loan loss allowances (see
Meyer, 1999). The SEC's regulatory intervention became a major source of concern to both banks and bank regulators who
jointly encouraged the US Congress to hold hearings. During Congressional testimony, a member of the Board of Governors
of the Federal Reserve, Meyer (1999), in response to the SEC's intervention, stated that:
The SEC raised concerns regarding the loan loss reserve practices of some banking organizations [by] requiring one
banking organization to reduce its reserves by $100 million. The federal banking agencies were concerned about these
actions from a safety and soundness standpoint….In addition, around this time, the SEC issued letters to a number
of banking organizations regarding their loan loss allowance disclosure practices. Taken together, these develop-
ments generated additional uncertainty in the banking industry and may have created a perception that loan loss
allowances would have to be reduced. (Emphasis added)
Senior Deputy Comptroller for Bank Supervision, Emory Rushton (1999) also took direct issue with the SEC's position that
banks were inflating their loan loss allowances. During Congressional testimony, Rushton (1999, p. 1) stated:
Our opinion is that national banks, as a group, are not materially over-reserved or under-reserved. That's why we're
so concerned about any [SEC] action that might have the effect, albeit unintended, of applying general downward
pressure on bank reserves. (Emphasis added)
2.4. SAB 102/FFIEC 2001 policy statement
The issuance of SAB 102 can be viewed as the culminating step in the SEC's intervention within the banking industry.
Furthermore, the SEC's ability to persuade the FFIEC to issue contemporaneously a Policy Statement (FFIEC, 2001) providing
identical guidance to SAB 102 indicates that the previous tension between the SEC and bank regulators subsided, at least
publicly. Both SAB 102 and the 2001 Policy Statement require banks to follow GAAP, use a consistent loan loss estimation
methodology, and implement controls over the loan loss estimation process. Previously, the 1993 FFIEC Policy Statement
and Comptroller's 1996–1998 Handbook required banks to adjust historical loss rates when estimating allowances. In contrast,
SAB 102 guidance permits adjustment, but fails to make adjustment of historical loss rates a requirement. A second change
introduced by SAB 102/FFIEC (2001) guidance is that banks are required to implement a control requiring periodic comparisons
of loan loss provisions and allowances with actual loss (charge-off) rates. We speculate that this control implicitly creates an
obligation to justify deviations between allowance estimates and charge-offs. Furthermore, as bank examiners and auditors are
required by SAB 102/FFIEC (2001) to review controls over the allowance estimation process, their control monitoring activities
are expected to reinforce its importance. Thus, we hypothesize that SAB 102 guidance and monitoring created several mutually
reinforcing incentives for banks to increase their reliance on historical charge-off rates when estimating loan loss allowances.
Whether bank regulators actually enforced the guidance in the FFIEC (2001) Policy Statement, however, is uncertain. At
face value, the 2001 Policy Statement represents a public commitment by the FFIEC to enforce SAB 102 guidance through
their examination and other regulatory monitoring activities. Meeting this commitment, however, would require bank
regulators to alter their traditional focus on allowance adequacy by also scrutinizing allowances for overstatement. Given
their prior opposition to the SEC's intervention and concerns about reducing allowances, an alternative interpretation is
that the 2001 Policy Statement served primarily as a symbolic or political gesture to placate the SEC. Under the latter
interpretation, it is possible that SAB 102 guidance was not enforced consistently by bank regulators.
2.5. New FFIEC policy statement
Concerns with the guidance in the SAB 102/2001 Policy Statement led the FFIEC (2005) to issue a new policy statement that
became effective for reporting periods after December 2006. The new policy statement emphasized the need for banks to adjust
their historical charge-off rates (used in estimating allowances) for changes in economic conditions and their own lending
policies.6 Thus, we conjecture that the FFIEC's (2005) policy statement was motivated by growing concerns at the time about the
dangers of placing heavy reliance on historical charge-off rates in the midst of changing economic conditions. In any event, the
revised guidance stops well short of the 1993 Policy Statement and the 1996–1998 Comptroller's Handbook requirement that
banks must adjust historical loss rates. A further difference is that the 2005 Policy Statement requires banks to justify
adjustments in supporting documentation and to subject both estimates and documentation to an independent review.
Additionally, the bank's board of directors is now required to review annually the bank's loan loss policies and procedures and
documentation while bank examiners and external auditors are required to evaluate allowance adequacy and controls over loan
loss estimation policies.
3. Hypotheses
In Section 2, we identified past charge-offs and non-performing loans (NPL) as being the two most widely used metrics
providing information about the riskiness of a bank's loan portfolio. In this section, we develop hypotheses about the effects of the
SEC's guidance on the relative importance accorded to these metrics in structuring loan loss allowances and the informativeness
consequences of these changes. While past researchers have used non-performing loans (NPL) or non-performing assets (NPA) as
timely risk measures, for methodological reasons, our analysis uses non-accrual loans (NAL) as the timely risk measure.7
3.1. Overall effects of SAB 102 guidance
We first formulate a hypothesis addressing all banks before considering how the effects vary across cross-sectional
partitions. Consistent with regulators' reliance on charge-offs and NAL as loan risk metrics, we expect that banks' loan loss
allowances will be positively associated with both NAL and charge-offs. However, since SAB 102 guidance requires banks to
justify their allowances vis-à-vis past charge-offs, we expect allowances to become more highly associated with past charge-
offs after the SEC's intervention and less associated with NAL, thus, leading to the following hypothesis:
H1. After the SEC's intervention, current allowances will be more associated with past charge-offs and less associated
with NAL.
3.2. Bank size effects and allowance associations
While H1 predicts that banks will place a greater emphasis on past charge-offs in structuring allowances and less
emphasis on NAL, we do not expect that all banks will respond uniformly to the SEC's regulatory influence and SAB 102
guidance. As many small banks are privately owned and do not come under the SEC's jurisdiction, the enforcement of SAB
102 guidance could vary with size. Furthermore, as noted by Altamuro and Beatty (2010), the Federal Deposit Insurance
Corporation Improvement Act (FDICIA) requires financial statement auditors and bank examiners to evaluate controls of
banks having assets over 500 million USD (later 1 billion USD). Altamuro and Beatty (2010) present evidence that these
control provisions of the FDICIA regulation led to differences in financial reporting quality between large and small banks.
Thus, large banks subject to the FDICIA's control requirements could be under greater pressure to comply with SAB 102
guidance than small banks. The size effect associated with SAB 102 is reinforced in later periods by the Sarbanes-Oxley Act
(SOX) as auditors of public banks report publicly their evaluations of control operating effectiveness.8 Thus, we hypothesize
the following size effect associated with enforcement of SAB 102/FFIEC guidance:
6
The FDIC's (2005) Risk Management Manual of Examination Policies (Section 3.2) states that, “While historical loss experience provides a reasonable
starting point, historical losses, or even recent trends in losses, are not by themselves, a sufficient basis to determine an adequate level. Management
should also consider any factors that are likely to cause estimated losses to differ from historical loss experience..”. The FDIC manual goes on to identify
several change factors including: “lending policies, loan volume, loan types, economic conditions, controls (lending policies and procedures, loan review,
board oversight, experience of lending managers), and the volume and severity of past due, nonaccrual, restructured, or classified loans, and concentrations
of credit.”
7
Dating back to Beaver et al. (1989), accounting researchers have included NPL or non-performing assets (NPA) as a control for loan portfolio risk. The
NPL category reported by banks to regulators (and to the SEC) represents an aggregation of two separate components: non-accrual loans (NAL) and
troubled debt restructured loans. NPA is even broader in that it includes both NPL and foreclosed assets. Since restructured loans and foreclosed assets are
reported at realizable value, expected losses on those loans already have been recorded. Thus, we would expect NAL to have a stronger association with
future losses than the more aggregate measures of NPA and NPL. As such, we employ NAL as a risk measure and formulate the hypotheses accordingly. The
robustness of our results to the NPA and NPL specifications is discussed in Section 5.
8
Control evaluations performed in accordance with FDICIA and bank audit/examination guidance (FDIC, 2005, 2010) only require evaluations of
control design and were not publicly disclosed. Under the Public Company Accounting Oversight Board's (PCAOB) Audit Standard (AS) 2 (and later Standard
5), controls over accounting estimates are highlighted as a significant risk area and, thus, are within the scope of Section 404 control evaluations for
virtually all public companies subject to SOX. Furthermore, under AS 2 (and later AS 5) auditors are required to go beyond control design evaluation under
H2. The association between the current allowance and past charge-offs (NAL) will increase (decrease) more among Large
Banks than among Small Banks after the SEC's intervention.
3.3. Earnings management incentives and allowance associations
Prior research indicates that high and low profit banks have incentives to manage allowances in different ways (Liu and
Ryan, 2006; Kanagaretnam et al., 2004). In particular, the smoothing hypothesis (Greenawalt and Sinkey, 1988) implies that
profitable (“Strong”) banks have incentives to accelerate loss provisioning while less profitable (“Weak”) banks will have
incentives to delay provisioning. During the time period of our study, delaying (accelerating) loan loss provisioning serves to
increase (reduce) both reported income and the bank's capital ratio.9 Thus, Weak Banks have mutually reinforcing incentives
to increase both reported income and bank capital by delaying loss provisioning while Strong Banks can smooth reported
earnings in the current (strong) period by accelerating loss provisioning. We make direct use of these mutually reinforcing
incentives when formulating cross-sectional hypotheses about the effects of the SEC's intervention.
Since the smoothing hypothesis predicts that Weak Banks have incentives to understate their loss provisions and
allowances, we would expect that bank regulators' focus on allowance adequacy will constrain earnings management
activities by the Weak Banks. However, given the incentives of Strong Banks to inflate allowances under the smoothing
hypothesis and the SEC's attention towards allowance overstatement, we would expect the SEC to scrutinize the Strong
Banks more. Thus, if bank regulators' focus on allowance adequacy remains stable, we would expect the SEC's intervention
and SAB 102 guidance to impact the earnings management activities and allowances of Strong Banks more than Weak
Banks10:
H3. The association between current allowances and past charge-offs (NAL) will increase (decrease) more among Strong
Banks than among Weak Banks in periods after the SEC's intervention.
While H3 predicts that allowance associations with past charge-offs will increase more for Strong Banks than for Weak
Banks, an important issue is whether allowance informativeness will be affected. The two hypotheses about informativeness
presented below differ in their assumptions about pre-SAB 102 earnings management and the informativeness of banks'
allowances. Ceteris paribus, if prior to SAB 102, banks had weighted the two risk indicators to maximize informativeness,
any changes induced by the new guidance would be expected to diminish allowance informativeness for all banks. However,
we do not expect that SAB 102 will have a uniform effect on the allowance estimation by Strong and Weak banks. Prior to
SAB 102, we expect that Strong Banks operating under conditions of stability will place comparatively more weight on
charge-offs than Weak Banks that place comparatively greater weight on more timely indicators such as NAL (Liu and Ryan,
1995, 2006; Ryan, 2007; Bhat et al., 2012). Thus, implementation of a charge-off centric allowance estimation approach
under SAB 102 will require Weak Banks to make more extensive changes than Strong Banks and, thus, have a more adverse
impact on informativeness. This reasoning, however, assumes implicitly that Weak Banks and Strong Banks will face the
same regulatory pressure to comply with SAB 102 guidance. If the SEC focuses on Strong Banks (as argued in H3) while bank
regulators retain their traditional focus on allowance adequacy, then Weak Banks could face less pressure to comply with
SAB 102. Such enforcement variability, thus, could attenuate the informativeness differences that would otherwise be expected
to exist for Strong and Weak Banks. Jointly considering these opposing effects leads to the following hypothesis:
H4. Forward allowance-charge-off associations will decline after the SEC's intervention and SAB 102, but the effects will not
differ between Strong and Weak Banks.
A maintained assumption underlying H4 is that, prior to SAB 102, banks structured allowances to maximize their
informativeness given the characteristics of their environments. Such an assumption, however, is inconsistent with the SEC's
premise that Strong Banks were overstating allowances to smooth income and, thereby, reducing the informativeness of
their financial reports. Thus, from the SEC's perspective, encouraging Strong Banks to increase reliance on charge-offs will
enhance informativeness by constraining their ability to create cookie jar reserves by accelerating provisioning. Given their
stable environments, Strong Banks also could potentially benefit from placing a high level of reliance on charge-offs under
SAB 102 guidance.
For Weak Banks, however, the lack of stability makes it rather unlikely that allowance informativeness will be enhanced
by placing greater reliance on charge-offs. Furthermore, the smoothing hypothesis predicts that Weak Banks will want to
(footnote continued)
FDICIA by evaluating the operating effectiveness of controls. Thus, as SOX applies to public banks but not to the small private banks, the size effects of SAB
102/FFIEC guidance are likely to be accentuated.
9
During earlier time periods, banks faced several trade-offs when managing earnings and managing capital ratios since allowances were added to
equity in calculating regulatory capital and loss provisions were tax deductible. Several early studies (see Moyer, 1990; Wahlen, 1994; Beatty et al., 1995;
Collins et al., 1995; Ahmed et al., 1999) hypothesized that banks' motivation to maintain capital ratios to satisfy bank regulators would influence loan loss
provisioning. These studies examined the trade-offs between the tax advantages of accelerating the expensing of loan losses to reduce taxes, the incentives
to smooth income, and compliance with capital ratios.
10
In developing hypotheses H4 and H4 Alternative regarding allowance informativeness for Weak and Strong Banks, we consider the possibility that
SAB 102 could affect bank regulators' focus on allowance adequacy.
Fig. 1. Time line for regulatory intervention.
delay loss provisioning, thus, leading to an understatement of allowances.11 It is not obvious that SAB 102 guidance will
symmetrically constrain the earnings management ability of Weak Banks. In fact, to the extent that reliance on charge-offs
(a lagging risk indicator relative to NAL) can be used to justify delays in provisioning (when facing scrutiny from bank
regulators), earnings management by Weak Banks could actually increase after SAB 102. Such behavior might arise,
for example, when economic conditions change adversely (as in the period just prior to the financial crisis) so that reliance
on historical (low) charge-offs can be a justification for delaying loss provisioning and understating allowances. These
arguments lead to the following alternative hypothesis:
H4 Alternative. The forward allowance-charge-off associations will increase for Strong Banks in periods after the SEC's
intervention, while the allowance-charge-off associations for Weak Banks will decrease.
4. Sample selection and data
4.1. Sample periods
Our sample extends from the fourth quarter of 1992 through 2008 with the 1992 start being chosen to exclude data from
regulatory regimes before Basel and the 2008 ending point being imposed to ensure the availability of at least one future
holdout year (2009) for our tests of future losses. Given the long time horizon, we divide the sample into six periods that are
depicted in Fig. 1.
Period 1 begins with year 1992 (after implementation of Basel) and also includes the 1993 FFIEC Policy Statement that
became effective in December 1993 and Statement of Financial Accounting Standards (SFAS) 114 issued in May 1993. The
economy was in a recession at the beginning of Period 1, so the smoothing hypothesis predicts that many banks would
have incentives to draw down their loan loss allowances. Period 1 ends with the 1994 phase-in of the 1992 FDICIA that
strengthened banks' controls (Altamuro and Beatty, 2010) Period 2 begins in 1995 after FDICIA and SFAS 114 became
effective and ends in 1997 before the SEC began its investigation of SunTrust Bank for allegedly overstating its loan loss
allowance. During Period 2, the economic recovery strengthened so the smoothing hypothesis predicts that many banks
would begin to increase their allowances. Period 3 begins in year 1998 when the SEC launched its public investigation of
SunTrust Bank's allowance and ends in year 2000 just prior to the SEC's promulgation of SAB 102.12
Period 4 includes years 2001 through 2004 during which time banks first became subject to SAB 102/FFIEC (2001)
guidance. With the exception of the fourth quarter of 2001 in the aftermath of the 9/11 terrorist attacks, the economy in this
period was characterized by strong growth in the real estate sector. During Period 5 (years 2005 and 2006), publicly owned
banks became subject to SOX. During Period 5, real estate prices (as measured by the Case-Shiller Index) reached a peak
in the second quarter of 2006. Period 6 (years 2007 and 2008) was characterized by declining real estate prices and loan
defaults as many banks developed financial problems in connection with their real estate loans. Another distinguishing
feature of Period 6 is that the FFIEC's (2005) Policy Statement became effective for reporting periods that began
11
As loan loss provisioning reduces capital, weak banks have additional incentives (apart from earnings management) for delaying loss provisioning.
During the time period of our study (1992–2008) delaying loan loss provisions increases both reported income and banks' capital ratios. This is in contrast
with earlier time periods (discussed in footnote 8) where banks faced trade-offs between tax/cash flow management, earnings management, and capital
management.
12
As noted above, this period is excluded from the aggregate analysis used in performing our initial tests of H1 as it was marked by considerable
regulatory competition between the SEC and the FFIEC bank regulators.
after December 2006. As noted previously, this Policy Statement modified the guidance in the SAB 102/FFIEC 2001 Policy
Statement by encouraging banks to anticipate changes in the economic environment. Thus, while we do not formulate
hypotheses about allowances in Period 6, we expect the influence of SAB 102 guidance to be diluted in Period 6 relative to
Periods 4 and 5. Given the changes in guidance applicable in Period 6, our tests of the effects of the SEC's intervention and
SAB 102 focus on a comparison of the regressions estimated for Periods 1 and 2 (pre-SAB 102) with regressions estimated
for Periods 4 and 5 (post-SAB 102).
4.2. Bank data
We obtain accounting data on bank holding companies from the Bank Regulatory Database provided by Wharton
Research Data Services. Table 1 provides the sample summary statistics for all variables organized by panels corresponding
to the six periods identified in Fig. 1.13 The sample sizes for the six periods vary substantially ranging from a low of 6,307
observations in Period 6 to a high of 25,419 observations in Period 3. The sample size differences within periods are
explained by differences in the number of quarters included within each period, the formation of new banks during
favorable economic conditions, and then a consolidation through merger activities.14 The differences in the variable means
across the six time periods in Table 1 provide the motivation for our differences-in-differences design. The mean total assets
of the banks in our sample increased from 3.30 billion dollars and 3.99 billion dollars during Periods 1 and 2 to means of
11.57 billion dollars and 12.58 billion dollars in periods 5 and 6, respectively. ALLOW (end-of-quarter loan loss allowance
scaled by ending loans outstanding) averages 1.88 percent and 1.56 percent in Periods 1 and 2.15 After the SEC's intervention,
ALLOW fell to 1.39 percent and 1.26 percent in Periods 4 and 5, respectively, before rising to 1.32 percent in Period 6. PROV
(quarterly loan loss provision scaled by ending quarterly loans outstanding) exhibits a pattern similar to ALLOW.
Table 1 also includes loan composition data for the proportion of total loans belonging to each of three loan categories:
non-mortgage loans to individuals (IND), commercial loans, (COM), and real estate loans (FREAL). The composition of banks'
loan portfolios changed over time with IND and COM both steadily declining. Both IND and COM declined respectively from
16.51% and 19.45% in Period 1 to 5.43% and 15.35% in Period 6. The two risk metrics are non-accrual loans (NAL) and charge-
offs (CHO). Both NAL and CHO are scaled by the ending quarterly book value of total loans receivable. AVECHO is a four-
quarter moving average of CHO. The risk metrics decline over time through Period 5 before increasing during the financial
crisis in Period 6. There are a small number of CHO and PROV observations that are negative. To avoid survivor bias concerns,
we have retained them in our analysis. However, all results are robust to the exclusion of these observations. Strong and
Weak Banks are distinguished by their earnings before provisions (EBP) and by their capital ratios. Since many banks did not
report their Tier 1 capital ratios, we constructed our own capital ratio proxy (CAPRATIO) defined as the ratio of total equity to
total assets. The average CAPRATIO fluctuated between a low of 8.22% in Period 1 and a high of 9.17% in Period 4.
In addition to the loan controls, we incorporate several macroeconomic controls. The first is CSRET: the return
on the Case-Shiller real estate index: (CS INDEXt CS INDEXt 1)/CS INDEXt 1. Second, we follow Beatty and Liao (2011) by
adding a control (DUNRATE) for macro-economic conditions representing the change in the quarterly unemployment rate
and a size control: SIZE – the natural logarithm of beginning of period (lagged) total assets. The quarterly CSRET mean ranged
from high of 2.62% during the housing boom in Period 4 down to a low of 3.56% in Period 6. The mean DUNRATE varied
from a low of 0.222% in Period 1 as the economy emerged from a recession to a high of 0.304% during the recession in
Period 6.
5. Empirical results
5.1. Aggregate association tests
To test hypothesis H1 about allowance determinants at an aggregate level, we estimate the association between the
current allowance and past charge-offs using the following model:
ALLOW ¼ α þ β1 AVECHO þ β2 NAL þ β3 POST þ β4 POST AVECHO þ β5 POST NAL þ β6 IND þ β7 COM þ β8 SIZE
þβ9 CSRET þ β10 DUNRATE þ ε : ð1AÞ
To capture changes in ALLOW in response to the SEC's regulatory intervention, we introduce the POST indicator variable
that takes on a value of one during periods after SAB 102 became effective (years 2001 through 2008) and zero in years
1992–97. The years 1992 through 1997 are clearly defined as the pre-SEC intervention period. Since the SEC's regulatory
intervention (e.g., investigation of SunTrust Bank) preceded the issuance of SAB 102, we follow the approach taken by Altamuro
and Beatty (2010) by initially excluding the transitional years 1998–2000 (Period 3) from our aggregate level analysis where the
POST indicator is interacted with AVECHO and NAL.
13
All variable definitions have also been provided in the appendix.
14
The cut-offs were designed to capture a priori differences in regulatory and economic conditions and, thus, were not chosen to equalize sample sizes.
15
We have also used beginning loan balances for scaling charge-offs and the results are unaffected. Additionally, AVECHO multiplied by four is
analogous to the sum of the past four quarterly charge-offs.
Table 1
Summary statistics.
Variable Mean Std. dev. Min Max
Panel A: Period 1 (1992–1994) N ¼ 10,164
Total Assets ('000) 3,304,962 13,921,797 20,070 254,246,000

FREAL 0.5746 0.1753 0.0000 1.0487
ALLOW 0.0188 0.0100 0.0000 0.1232
PROV 0.0011 0.0029 0.0996 0.0500
NAL 0.0122 0.0162 0.0000 0.2104
CAPRATIO 0.0822 0.0252 0.0298 0.4986
EBP 0.0109 0.0081 0.1600 0.1303
SIZE 13.2313 1.4859 9.9070 19.3538
CHO 0.0016 0.0029 0.0027 0.0523
CHO (Adjusted) 0.0011 0.0028 0.0475 0.0494
LOSS 0.0342 0.1819 0.0000 1.0000
PROFIT 0.4477 0.4973 0.0000 1.0000
IND 0.1651 0.1182 0.0000 1.0000
COM 0.1945 0.1214 0.0000 0.9576
CSRET 0.0037 0.0096 0.0088 0.0209
DUNRATE 0.2222 0.1106 0.3667 0.0667
Panel B: Period 2 (1995–1997) N¼ 13,577
Total Assets ('000) 3,991,724 19,830,201 26,618 366,574,000

FREAL 0.5985 0.1802 0.0000 1.0610
ALLOW 0.0156 0.0074 0.0000 0.1461
PROV 0.0009 0.0023 0.1191 0.0626
NAL 0.0072 0.0091 0.0000 0.1416
CAPRATIO 0.0909 0.0318 0.0044 0.9018
EBP 0.0116 0.0073 0.0512 0.2071
SIZE 13.2863 1.4293 10.1893 19.7197
CHO 0.0011 0.0018 0.0104 0.0452
CHO (Adjusted) 0.0007 0.0029 0.2636 0.0431
LOSS 0.0099 0.0992 0.0000 1.0000
PROFIT 0.4322 0.4954 0.0000 1.0000
IND 0.1555 0.1175 0.0000 1.0000
COM 0.1871 0.1226 0.0000 1.0000
CSRET 0.0071 0.0093 0.0066 0.0211
DUNRATE 0.0806 0.1291 0.2333 0.2000
Panel C: Period 3 (1998–2000) N¼ 15,481
Total Assets ('000) 4,816,162 34,131,698 30,364 902,210,000

FREAL 0.630 0.175 0.000 1.014
ALLOW 0.014 0.006 0.000 0.106
PROV 0.001 0.002 0.044 0.072
NAL 0.006 0.007 0.000 0.137
CAPRATIO 0.0916 0.0335 0.0040 0.7065
EBP 0.011 0.009 0.044 0.221
SIZE 13.239 1.367 10.321 20.620
CHO 0.001 0.002 0.005 0.056
CHO (Adjusted) 0.001 0.002 0.044 0.056
LOSS 0.012 0.107 0.000 1.000
PROFIT 0.439 0.496 0.000 1.000
IND 0.1267 0.1032 0.0000 0.9729
COM 0.1809 0.1170 0.0000 0.9765
CSRET 0.0203 0.0090 0.0079 0.0377
DUNRATE 0.0639 0.0989 0.2333 0.1333
Panel D: Period 4 (2001–2004) N ¼25,419
Total Assets ('000) 6,262,300 53,507,530 37,778 1,484,101,000

FREAL 0.6820 0.1595 0.0000 1.0104
ALLOW 0.0139 0.0072 0.0000 0.2572
PROV 0.0011 0.0026 0.0151 0.1332
NAL 0.0073 0.0094 0.0000 0.2283
CAPRATIO 0.0917 0.0354 0.0036 0.8300
EBP 0.0106 0.0087 0.0611 0.3611
SIZE 13.2267 1.3421 10.5395 21.1181
CHO 0.0011 0.0026 0.0191 0.1436
CHO (Adjusted) 0.0008 0.0024 0.0235 0.1344
Table 1 (continued )
Variable Mean Std. dev. Min Max
LOSS 0.0121 0.1094 0.0000 1.0000

PROFIT 0.4370 0.4960 0.0000 1.0000
IND 0.0922 0.0896 0.0000 0.9799
COM 0.1662 0.1002 0.0000 0.8357
CSRET 0.0262 0.0102 0.0063 0.0455
DUNRATE 0.0958 0.2485 0.3000 0.6667
Panel E: Period 5 (2005–2006) N ¼ 7,435
Total Assets ('000) 11,566,527 88,525,487 61,427 1,884,318,000

FREAL 0.7390 0.1514 0.0000 1.0093
ALLOW 0.0126 0.0080 0.0000 0.2303
PROV 0.0007 0.0017 0.0133 0.0493
NAL 0.0051 0.0067 0.0000 0.1271
CAPRATIO 0.0883 0.0363 0.0094 0.7349
EBP 0.0105 0.0103 0.0420 0.2938
SIZE 14.0310 1.3295 11.0256 21.3568
CHO 0.0007 0.0020 0.0121 0.0560
CHO (Adjusted) 0.0005 0.0017 0.0125 0.0432
LOSS 0.0128 0.1123 0.0000 1.0000
PROFIT 0.4662 0.4989 0.0000 1.0000
IND 0.0613 0.0773 0.0000 0.9696
COM 0.1540 0.0967 0.0000 0.7714
CSRET 0.0171 0.0211 0.0096 0.0444
DUNRATE 0.1250 0.0707 0.2000 0.0333
Panel F: Period 6 (2007–2008) N ¼ 6,307
Total Assets ('000) 12,577,047 105,825,682 71,152 2,358,266,000

FREAL 0.7462 0.1490 0.0000 1.0068
ALLOW 0.0131 0.0087 0.0000 0.2211
PROV 0.0018 0.0039 0.0077 0.0743
NAL 0.0125 0.0182 0.0000 0.2768
CAPRATIO 0.0892 0.0399 0.0240 0.7853
EBP 0.0076 0.0119 0.1642 0.2650
SIZE 14.0703 1.2602 11.1726 21.5812
CHO 0.0014 0.0034 0.0197 0.0617
CHO (Adjusted) 0.0013 0.0032 0.0239 0.0544
LOSS 0.0931 0.2906 0.0000 1.0000
PROFIT 0.4140 0.4926 0.0000 1.0000
IND 0.0543 0.0752 0.0000 0.8607
COM 0.1535 0.0960 0.0000 0.7964
CSRET 0.0356 0.0257 0.0739 -0.0086
DUNRATE 0.3042 0.3021 0.0333 0.8000
ALLOW: Allowance at the end of the quarter scaled by total loans outstanding at the end of the quarter. Computed as BHCK3123/BHCK2122. CAPRATIO: The
end of quarter Total Equity scaled by Total Assets. CHO: Charge offs for the quarter divided by the average loans outstanding for the quarter. Year-to-date
charge-offs are available as data item BHCK4635. CHO (Adj.): CHO adjusted by next quarter's recoveries and scaled by the average loans outstanding for the
quarter. Year-to-date recoveries are available as data item BHCK4605. COM: Commercial Loans as a fraction of Total Loans. Computed as BHCK1766/BHCK
2122. EBP: Earnings before provisions computed as the company's earnings after tax plus provisions for the quarter (scaled by lagged Total Assets). Year-to-
date provisions are available as data item BHCK4230. FREAL: Fraction of loans outstanding that are secured by real estate. Computed as BHCK1410/
BHCK2122. IND: Individual Non-Mortgage Loans as a fraction of Total Loans. Computed as BHCK1975/BHCK 2122. LOSS: An indicator variable that takes on a
value of one if the bank declared a loss for the year and zero otherwise. NAL: Non-accrual loans at of the end of the quarter divided by total loans
outstanding at the end of the quarter. PROFIT: An indicator variable that equals one if the company's EBP is in the upper half of the industry wide
distribution of EBP for the quarter and zero otherwise. PROV: Loan Loss Provisions for the quarter. Year-to-date provisions are available as data item BHCK
4230. Size: The natural logarithm of Total Assets. Total Assets: The end of quarter total assets of the bank holding company in millions. Available as data item
BHCK2170.
Panel A of Table 2 presents two regressions that are employed to test hypothesis H1. The first uses reported CHO as the
basis for calculating AVECHO, while the second adjusts quarterly charge-offs with future recoveries before averaging.16
The standard errors and t-values in all regressions are conservative in that they are adjusted for both year-level and firm-
level clustering using the two-way clustering approach advocated in Peterson (2009).
16
Liu and Ryan (2006) contend that banks will have incentives to provide justification for increased loan loss provisioning by inflating charge-offs.
However, they hypothesize that such behavior will be revealed ex post by large charge-off recoveries. Accordingly, we attempt to remove the effects of such
charge-off management by adjusting charge-offs for recoveries and test that our results are robust to employing adjusted charge-offs.
Table 2
Determinants of allowance and provisions.
Panel A: Allowance Panel B: Loss Provisions
Unadjusted charge-offs Adjusted charge-offs Provision Model 1 Provision Model 2

ALLOW (Eq. (1A)) ALLOW (Eq. (1A)) PROV (Eq. (1B)) PROV (Eq. (1B))
AVECHO 1.507nnn 0.489n ALLOWLAG 0.031nnn

(14.380) (1.928) ( 2.719)
NAL 0.246nnn 0.333nnn CHO 0.679nnn CHO 0.636nnn
(13.325) (13.995) (24.863) (33.300)
POST 0.002nnn 0.002nn DNAL 0.050nnn DNAL 0.055nnn
( 3.157) ( 2.200) (5.354) (6.087)
POST AVECHO 1.110nnn 2.349nnn POST 0.000 POST 0.000
(2.741) (3.881) (0.178) (1.049)
POST NAL 0.185nnn 0.261nnn POST CHO 0.215nnn POST CHO 0.203nnn
( 6.508) ( 7.473) (3.477) (3.590)
IND 0.002 0.003 POST DNAL 0.024n POST DNAL 0.019
( 1.215) (1.462) (1.942) (1.577)
COM 0.006nnn 0.008nnn IND 0.000 IND 0.001
(3.974) (4.832) (0.925) (1.441)
POST IND 0.001 0.001 COM 0.001nn COM 0.001n
(0.458) ( 0.355) (2.447) (1.784)
POST COM 0.003 0.004nn POST IND 0.000 POST IND 0.000
( 1.610) ( 2.333) (0.072) ( 0.649)
SIZE 0.000 0.000 POST COM 0.001nn POST COM 0.001n
(1.340) (1.588) ( 2.049) ( 1.646)
DUNRATE 0.001 0.001n SIZE 0.000 SIZE 0.000
( 1.417) ( 1.698) ( 0.407) ( 1.323)
CSRET 0.014nnn 0.015nnn DUNRATE 0.000nn DUNRATE 0.000nn
(4.108) (3.959) (2.167) (2.454)
Intercept 0.009nnn 0.007nnn CSRET 0.003nnn CSRET 0.003nnn
(4.261) (3.293) ( 3.294) ( 4.250)
Intercept 0.001nnn Intercept 0.000
(3.155) (1.622)
N 62,902 62,899 62,834 62,834
Adj. R-sq 0.517 0.462 0.586 0.580
t Statistics in parentheses (standard errors adjusted for two-way clustering – firm and year).
ALLOW: Allowance at the end of the quarter scaled by total loans outstanding at the end of the quarter. Computed as BHCK3123/BHCK2122. ALLOWLAG:
Allowance at the beginning of the quarter. AVECHO: The average of CHO or CHO (Adj.) for the current and past three quarters. CHO: Charge offs for the
quarter divided by the average loans outstanding for the quarter. Year-to-date charge-offs are available as data item BHCK4635. CHO (Adj.): CHO adjusted by
next quarter's recoveries and scaled by the average loans outstanding for the quarter. Year-to-date recoveries are available as data item BHCK4605. COM:
Commercial Loans as a fraction of Total Loans. Computed as BHCK1766/BHCK 2122. CSRET: The return on the Case-Shiller Real estate Index over the quarter.
DNAL: The change in NAL from the beginning of the quarter to the end. DUNRATE: The change in the unemployment rate from the beginning of the quarter
to the end. IND: Individual Non-Mortgage Loans as a fraction of Total Loans. Computed as BHCK1975/BHCK 2122. NAL: Non-accrual loans at of the end of
the quarter divided by total loans outstanding at the end of the quarter. POST: An indicator variable that takes on a value of one for the years 2001–2008
and a value of zero for the years 1992–1997. PROV: Loan Loss Provisions for the quarter. Year-to-date provisions are available as data item BHCK 4230. Size:
The natural logarithm of Total Assets. Total Assets: The end of quarter total assets of the bank holding company in millions. Available as data item BHCK2170.
n
p o 0.1.
nn
p o 0.05.
nnn
po 0.01.
In Panel A of Table 2, the POST indicator is negative and significant (p o.01 and po.05, respectively) in the two
regressions implying that banks' loan loss allowances declined (as a percentage of loans outstanding) after SAB 102. The
decline implies an overall downward shift in allowances following the SEC's intervention. Furthermore, as predicted by H1,
the POST interactions with AVECHO are positive and significant (p o.01), while POST interactions with NAL are negative and
significant (p o.01) in both regressions. When AVECHO is adjusted for recoveries, the POST interaction with AVECHO is 2.349,
thus, indicating that the allowance-charge-off associations increased from 0.489 during the pre-intervention period to 2.838
(0.489+2.349) during the post-intervention period. In contrast, the POST-NAL interaction declined from 0.333 in the pre-
intervention period to 0.072 (0.333–0.261) in the post-SAB 102 period. These results are fully consistent with H1's prediction
that banks' allowances became more responsive to AVECHO, but less responsive to NAL in periods after the issuance of SAB
102. The control variables, CSRET and COM are significant (po.01) in both allowance regressions, while SIZE and IND are not
significant in either allowance regression.
The choice of ALLOW as the dependent variable is because the focus of bank regulators and the SEC has been on
allowances with SAB 102/FFIEC guidance applying directly to the estimation of loan allowances. However, to facilitate
comparisons between our allowance results and those of prior studies that have focused on provisions, we also estimate
a second regression model in which ALLOW is replaced by the loan loss provision (PROV). Consistent with the scaling of
ALLOW in (1A), PROV is divided by ending loans receivable:

PROV ¼ α þ β1 CHO þ β2 DNAL þ β3 POST þ β4 POST CHO þ β5 POST DNAL þ β6 IND þ β7 COM þ β8 SIZE þ β9 CSRET
þβ10 DUNRATE þ β11 ALLOWLAG þ ε : ð1BÞ
As PROV is a flow variable, some minor changes in the explanatory variables have been made to accommodate the
dependent variable specification in (1B). The first is to replace NAL and AVECHO with DNAL (the change in NAL) and CHO.
The prior quarter's ending allowance (ALLOWLAG) is added to control for any over-accrual or under-accrual present at the
beginning of the current quarter that would require a provision adjustment. Since a large beginning of period allowance
balance allows banks to reduce their provisioning, we expect the coefficient on ALLOWLAG to be negative in (1B). While
ALLOWLAG controls for the size of the allowance at the beginning of the period, it is an imperfect proxy for the extent of
under or over-funding that is not directly observable. All other explanatory variables in (1B) are the same as in (1A). Based
on H1, we expect the β4 coefficient on the POST CHO interaction to be positive in (1B) and the POST DNAL interaction, β5
to be negative (assuming that the increased focus on CHO leads to a reduced emphasis being placed on DNAL).
In Panel B of Table 2, we present two regressions that explain quarterly loan loss provisions. The first provision regression
is based on (1B) while second provision regression excludes ALLOWLAG. In the first provision regression, the coefficient on
ALLOWLAG is negative and significant (po.01) in Model 1 as predicted. Paralleling the results for the allowance regressions,
the POST interactions with CHO are positive and significant (po.01) in both provision regressions, thus, indicating that
banks' loan loss provisions became more responsive to charge-offs after issuance of SAB 102 as predicted by H1. However,
the POST interactions with DNAL are small, suggesting that the effect of DNAL on provisions has not changed following
the SEC's intervention. The IND control is not significant in either of the provision regressions, while the DUNRATE, COM, and
CSRET controls remain significant in both provision regressions.
5.2. Disaggregated analysis of loan loss allowances using bank size
In this section, we take a more detailed look at how the SEC's intervention influenced banks' loan loss allowances by
splitting the sample into six, shorter time periods.17 We also partition the data for each period based on bank size to test H2.
This approach not only avoids having to include the post variable and its numerous interactions, but it also permits an
analysis of the effects on R2 in addition to the effect on the regression coefficients. In the interest of brevity, we henceforth
present results only for the allowance regressions with unadjusted charge-offs since the results are similar to those obtained
using provisions and adjusted charge-offs. Within each time period, we partition banks based on median asset size into
Large and Small groups and estimate regressions separately for each size group.18
The allowance regression results for Large Banks are presented in Panel A of Table 3 while those for Small Banks are
presented in Panel B. Since we conduct disaggregated analyses within each period, Eq. (1A) is estimated without the POST
indicator and interactions. The AVECHO coefficients for both the Large and Small Banks are significant (p o.01) in all periods
and are generally increasing over time. We calculate differences between the AVECHO coefficients for the Large and Small
Banks and evaluate their significance using the approach developed by Paternoster et al. (1998) for estimating the standard
error.19 The z-statistics indicate that the AVECHO coefficients are significantly larger for the Large Banks in all six periods. In
contrast, the Large Banks' NAL coefficients are consistently smaller with the differences being significant in Periods 3 and 6.
Comparisons of the average AVECHO coefficients for Periods 4 and 5 versus Periods 1 and 2 indicate that the AVECHO
coefficients increased by 1.726 for the Large Banks, but only by 0.578 for the Small Banks. The z-statistics for differences-in-
differences indicate that the increase for the Large Banks is significantly greater than the increase for the Small Banks
(p o.01).20 These results are consistent with the prediction under H2 that Large Banks are subject to greater scrutiny and,
17
Needless to add, while we document differences along hypothesized lines in each of the sub-periods, the results are only stronger if the sub-periods
are pooled into pre- and post- SEC action partitions.
18
In an earlier version of this paper presented at the JAE Conference, we defined the “Large Bank” group to include only the 50 largest banks. However,
the Discussant provided evidence showing that the hundred largest banks experienced a much greater shift toward real estate loans in periods after SAB
102 than did our “Small Banks.” To reduce the confounding effects of changes in banks' loan portfolios, we now partition based on median asset size
and remove the hundred largest banks from the “Large Bank” subsample. Consistent with the data presented by the Discussant, the Large and Small bank
groups so formed do not exhibit major differences in their loan proportions.
19
There are alternative approaches available for calculating the standard error of the coefficient differences. The most common approach employs the
use of a weighted average standard error based on the degrees of freedom in each regression. However, Paternoster, et al. (PBMP) (1998) and Clogg et al.
(1995) demonstrate that, for large sample studies (both N4 30), this Standard Error estimator is negatively biased (produces error estimates that are too
small), so that the resulting z-statistics are too large, thus, promoting Type I errors. We follow PBMP by adopting the following formula for the standard
error of the coefficient difference for Groups 1 and 2 denoted by bG1 bG2: √[SE(bG1)2+SE(bG2)2] yielding a z-statistic (PBMP) that is computed as z ¼
(bG1 bG2)/√[SE(bG1)2+SE(bG2)2], where SE(bG1) and SE(bG2) refer to the standard errors of the b coefficient in Groups G1 and G2 regressions,
respectively.
20
Since our hypotheses deal with differences in differences, we first need to compare the average of the coefficients in periods 1 and 2 with the
average of the coefficients in 4 and 5 (Difference 1). Focusing on Group 1, the coefficients b1 and b2 in periods 1 (with standard error SE 1) and 2 (SE 2) are
likely positively correlated. We assume that a conservative (high) estimate of the average coefficient standard error is SE 12¼the average of SE 1+SE 2
(assuming perfect correlation). Similarly the standard error for the average coefficient in periods 4 and 5 will be SE 45¼the average of SE 4 and SE 5. We
then compute the difference (Difference 1) in the average coefficient for Group 1 using the PBMP approach, i.e., the standard error of differences between
45 and 12 is SE 4512 ¼√[(SE 12)2+(SE 45)2]. We compute Difference 1 for Group 2 in a similar manner. For the difference in differences, we employ the
PBMP approach again yielding a standard error computed as √[(G1 SE 4512)2+(G2 SE 4512)2].
Table 3
Determinants of Allowance for Large and Small Banks (Eq. (1A) without the indicator variable).
Dep. Var: ALLOW Period 1 Period 2 Period 3 Period 4 Period 5 Period 6 Difference in averages
1992–1994 1995–1997 1998–2000 2001–2004 2005–2006 2007–2008 of Periods 4&5 and 1&2
Panel A: Large Banks excluding the top 100 banks
AVECHO 1.602nnn 1.755nnn 2.556nnn 2.594nnn 4.215nnn 3.426nnn 1.726nnn

(9.862) (15.392) (4.764) (13.190) (30.036) (12.153) (7.92)
NAL 0.221nnn 0.185nnn 0.041 0.068nn 0.010 0.048nnn 0.174nnn
(7.139) (7.556) (0.810) (2.468) ( 0.127) (3.252) ( 2.98)
IND 0.004nn 0.005nnn 0.005nnn 0.002 0.007nnn 0.001
( 2.069) ( 2.858) ( 2.634) ( 0.929) ( 4.441) ( 0.199)
COM 0.006nnn 0.008nnn 0.007nnn 0.005nnn 0.003nn 0.002
(2.972) (3.389) (2.863) (3.130) (2.078) ( 0.883)
SIZE 0.002nnn 0.001nnn 0.001n 0.000nn 0.000 0.000
(6.700) (4.248) (1.914) (2.162) (0.206) ( 0.004)
DUNRATE 0.001 0.002n 0.000 0.000nnn 0.000 0.002
(0.911) (1.585) (0.126) ( 37.551) (0.000) (0.000)
CSRET 0.023n 0.003 0.009nn 0.003 0.005 0.011nnn
(1.868) ( 0.158) ( 2.131) (0.000) (0.000) (3.189)
Intercept 0.015nnn 0.002 0.003 0.005n 0.009nn 0.010nn
( 3.455) ( 0.594) (0.704) (1.736) (2.469) (1.961)
N 4,180 5,586 6,537 11,106 2,915 2,350

Adj. R-sq 0.449 0.281 0.343 0.680 0.872 0.838
Panel B: Small Banks
AVECHO 1.138nnn 1.200nnn 1.041nn 1.691nnn 1.801nnn 1.376nnn 0.578

(10.596) (4.825) (2.260) (4.345) (7.019) (5.616) (1.57)
NAL 0.237nnn 0.253nnn 0.279nnn 0.110nnn 0.091nnn 0.108nnn 0.145nnn
(9.352) (6.429) (3.841) (3.871) (5.260) (5.330) ( 3.65)
IND 0.001 0.004nn 0.006nnn 0.001 0.001 0.003
(0.375) ( 2.371) ( 3.771) (0.253) (0.331) (1.350)
COM 0.002 0.003 0.000 0.002 0.004nnn 0.005nnn
(0.834) (1.285) ( 0.146) (1.336) (2.832) (3.496)
SIZE 0.001nn 0.001 0.000 0.000 0.000 0.000
( 2.151) ( 1.396) (0.242) ( 0.148) (1.077) ( 0.031)
DUNRATE 0.000 0.002n 0.001nnn 0.001nn 0.001 0.001nnn
(0.135) (1.955) ( 2.922) ( 1.979) (0.000) ( 3.560)
CSRET 0.004 0.012 0.006 0.001 0.004 0.004
(0.286) ( 0.564) ( 1.374) (0.578) (0.000) (1.525)
Intercept 0.024nnn 0.023nnn 0.010nn 0.012n 0.006 0.010nnn
(4.621) (3.050) (1.964) (1.836) (1.392) (2.857)
N 5,084 6,791 7,744 12,713 3,720 3,157

adj. R-sq 0.386 0.251 0.267 0.271 0.353 0.505
t Statistics (z for differences) in parentheses [standard errors adjusted for two-way clustering – firm and year]
Test for significance of difference in coefficients between Large and Small Banks Difference in differences
nnn nn nn nn nnn nnn

AVECHO 0.464 0.556 1.515 0.903 2.413 2.050 1.148nnn
z-Statistic (2.38) (2.03) (2.14) (2.07) (8.25) (5.49) (2.68)
NAL 0.016 0.068 0.238nnn 0.042 0.100 0.061nn 0.029
z-Statistic ( 0.40) ( 1.46) ( 2.68) ( 1.07) ( 1.30) ( 2.42) ( 0.42)
AVECHO: The average of CHO for the current and past three quarters. CHO: Charge offs for the quarter divided by the average loans outstanding for the
quarter. Year-to-date charge-offs are available as data item BHCK4635. COM: Commercial Loans as a fraction of Total Loans. Computed as BHCK1766/BHCK
2122. CSRET: The return on the Case-Shiller Real estate Index over the quarter. DUNRATE: The change in the unemployment rate from the beginning of the
quarter to the end. IND: Individual Non-Mortgage Loans as a fraction of Total Loans. Computed as BHCK1975/BHCK 2122. Large Banks: Banks in the upper
half of each quarter's distribution of Total Assets but not among the top 100 banks in Total Assets in the quarter. NAL: Non-accrual loans at of the end of the
quarter divided by total loans outstanding at the end of the quarter. Size: The natural logarithm of Total Assets. Small Banks: Banks in the lower half of each
quarter's distribution of Total Assets. Total Assets: The end of quarter total assets of the bank holding company in millions. Available as data item BHCK2170.
n
p o 0.1.
nn
p o 0.05.
nnn
po 0.01.
Table 4
Determinants of Allowance – Strong and Weak Banks by Capital Ratio (Eq. (1A) without the indicator variable).
Dep. Var: Period 1 Period 2 Period 3 Period 4 Period 5 Period 6 Difference in averages
ALLOW 1992–1994 1995–1997 1998–2000 2001–2004 2005–2006 2007–2008 of Periods 4&5 and 1&2
Panel A: Strong Banks

(12.952) (9.742) (7.163) (21.942) (10.840) (6.309) (4.78)
NAL 0.198nnn 0.178nnn 0.194nn 0.055nnn 0.022 0.026 0.150nnn
(5.489) (5.440) (2.115) (5.815) (0.781) (1.193) ( 3.81)
IND 0.004nn 0.006nn 0.007nnn 0.003 0.007nnn 0.003
( 2.006) ( 2.210) ( 4.178) ( 1.398) ( 3.049) (0.571)
COMM 0.005nnn 0.009nnn 0.004 0.004nnn 0.004nnn 0.002
(3.262) (4.271) (1.356) (2.810) (2.727) (1.052)
SIZE 0.001nnn 0.000nn 0.000 0.000 0.000nnn 0.000
(3.122) (2.414) (1.575) (0.098) ( 3.777) ( 0.737)
DUNRATE 0.000 0.002n 0.000nn 0.000n 0.000 0.001nnn
( 0.171) (1.773) ( 2.092) ( 1.907) (0.000) ( 4.793)
CSRET 0.026nnn 0.010 0.006nnn 0.000 0.007 0.004
(3.582) ( 0.378) ( 4.827) ( 0.064) (0.000) (0.913)
Intercept 0.005 0.007nnn 0.008nnn 0.011nnn 0.016nnn 0.013nnn
(1.520) (2.963) (4.365) (8.406) (9.433) (3.531)
N 5,080 6,786 7,737 12,706 3,715 3,150

adj. R-sq 0.386 0.235 0.381 0.636 0.829 0.746
Panel B: Weak Banks
AVECHO 1.051nnn 1.256nnn 0.927nnn 1.208nnn 0.815nnn 1.145nnn 0.142

(6.758) (8.113) (7.304) (4.225) (3.673) (6.222) ( 0.48)
(8.236) (8.197) (9.118) (9.541) (3.833) (22.717) ( 2.69)
IND 0.002 0.003nnn 0.002 0.001 0.002 0.006nnn
( 0.986) ( 2.755) ( 1.258) (0.896) (1.182) (3.178)
COMM 0.001 0.004n 0.005nnn 0.005nnn 0.006nnn 0.004nnn
(0.416) (1.773) (4.311) (5.781) (6.143) (3.910)
SIZE 0.001nnn 0.001nnn 0.000nnn 0.000 0.000nnn 0.000
(8.286) (5.539) (3.417) (0.697) ( 3.519) ( 0.122)
DUNRATE 0.001 0.002n 0.000 0.000nnn 0.000 0.001nnn
(0.686) (1.750) ( 0.779) ( 4.802) (0.000) ( 27.534)
CSRET 0.016 0.009 0.008nn 0.003 0.003 0.005nnn
( 0.962) ( 0.430) ( 2.299) (0.000) (0.000) (7.403)
Intercept 0.005nn 0.001 0.006nnn 0.009nnn 0.014nnn 0.009nn
( 2.480) ( 0.754) (5.823) (5.137) (11.065) (2.060)
N 5,084 6,791 7,744 12,713 3,720 3,157

Adj. R-sq 0.504 0.368 0.292 0.373 0.211 0.511
Difference in differences
Test for significance of difference in coefficients between Strong and Weak Banks Difference in differences
nnn nn nnn nnn nnn nnn

AVECHO 0.879 0.570 1.829 1.459 3.082 1.673 1.546nnn
z-Statistic (4.08) (2.35) (4.51) (4.70) (7.29) (3.46) (3.70)
NAL 0.084nnn 0.107nnn 0.031nnn 0.107nnn 0.139nnn 0.129nnn 0.027
z-Statistic ( 1.68) ( 2.24) ( 0.33) ( 5.47) ( 2.76) ( 5.75) ( 0.46)
ALLOW: Allowance at the end of the quarter scaled by total loans outstanding at the end of the quarter. Computed as BHCK3123/BHCK2122. AVECHO: The
average of CHO for the current and past three quarters. CAPRATIO: The end of quarter Total Equity scaled by Total Assets. CHO: Charge offs for the quarter
divided by the average loans outstanding for the quarter. Year-to-date charge-offs are available as data item BHCK4635. COM: Commercial Loans as a
fraction of Total Loans. Computed as BHCK1766/BHCK 2122. CSRET: The return on the Case-Shiller Real estate Index over the quarter. DUNRATE: The change
in the unemployment rate from the beginning of the quarter to the end. IND: Individual Non-Mortgage Loans as a fraction of Total Loans. Computed as
BHCK1975/BHCK 2122. NAL: Non-accrual loans at of the end of the quarter divided by total loans outstanding at the end of the quarter. Size: The natural
logarithm of Total Assets. STRONG BANKS: Banks in the upper half of each quarter's distribution of CAPRATIO. Total Assets: The end of quarter total assets of
the bank holding company in millions. Available as data item BHCK2170. WEAK BANKS: Banks in the lower half of each quarter's distribution of CAPRATIO.
n
p o 0.1.
nn
p o 0.05.
nnn
po 0.01.
thus, will be impacted more by SAB 102 than Small Banks. Given an increasing emphasis on AVECHO by the Large Banks,
their NAL coefficients are consistently smaller than the NAL coefficients for the Small Banks. A comparison of the average
NAL coefficient for Periods 1 and 2 with the average for Periods 4 and 5 indicates that the NAL coefficient change was 0.174
for the Large Banks versus 0.145 for the Small banks. However, z-statistics for differences-in-differences indicate that the
decreases in the NAL coefficients for the Large and Small Banks are not significantly different.
5.3. Cross-sectional analysis by bank strength
In addition to bank size, profitability and capital ratios were hypothesized in Section 3 to affect banks' incentives
to manage loss provisions and allowances. While earnings before provisions (EBP) provides the most direct means of
distinguishing banks' earnings management incentives and has been used widely in the literature, there is a concern herein
that such sorting could introduce a bias in that bank profitability could influence the types of loans that are made and vice
versa. One such possibility is that some banks achieve higher profitability (EBP) by making riskier loans, thus, resulting in
riskier loan portfolios. If banks anticipate their elevated default risk and increase their allowances accordingly, then the
stronger correlations between current charge-offs and allowances among profitable banks could be driven mechanistically
by differences in default risk rather than by SAB 102.
As loss provisioning has directionally consistent effects on both earnings and capital ratios, we avoid possible
mechanistic effects that could be induced by partitioning directly on EBP by sorting banks each quarter based on their
capital ratios and assigning them to “Strong” and “Weak” groups based on whether they are above or below the median
CAPRATIO within the quarter. Panel A of Table 4 reports the allowance regression results for the Strong Banks having above-
median capital ratios, while Panel B reports the results for the Weak Banks with below-median capital ratios.
Several trends are apparent in Table 4. First, the AVECHO coefficients and R2 values for the Strong Banks are larger in
Periods 4 and 5 versus Periods 1 and 2 while the NAL Coefficients are smaller. In contrast, the AVECHO coefficients and
R2 values for the Weak Banks do not exhibit systematic increases over time and the decrease in NAL Coefficients is smaller.21
Comparing the average AVECHO coefficient for Periods 1 and 2 against the corresponding average in Periods 4 and 5
indicates that the change (increase) is 1.403 (p o.01). A comparison of the average coefficients during the same time periods
for the Weak Banks indicates that the AVECHO coefficient change is 0.142. The difference-in-differences analysis indicates
that the change for the Strong Banks is significantly larger than for the Weak Banks as predicted by H3. The average
NAL coefficient change between Periods 1 and 2 and Periods 4 and 5 is -0.150 for the Strong Banks relative to 0.122 for the
Weak Banks. While each difference is significant (po.01), the difference-in-difference is not significant.22
Fig. 2A depicts the AVECHO and NAL coefficients for the Strong and Weak Banks across the six periods. For the Strong
Banks, we observe a dramatic crossing pattern in which the NAL coefficients decrease over time while the AVECHO
coefficients increase. For the Weak Banks, we do not observe large increases for the AVECHO coefficients over time and the
decline in the NAL coefficients is also smaller. These results are consistent with Strong Banks' being subject to greater
regulatory scrutiny than Weak Banks under H3.
5.4. Cross-sectional analysis of allowance informativeness
While the structural changes in the ALLOW regressions depicted above in Table 4 and Fig. 2A are quite dramatic, a key
issue is whether the informativeness of ALLOW is affected by the changes. Hypotheses H4 and H4 Alternative regarding SAB
102's allowance informativeness effects are tested by separately estimating the following regression for the Strong and Weak
Bank partitions within each of the six time periods:
AVECHOtþ4 ¼ α þ β1 ALLOW t þ β2 FREALt þ β3 INDt þ β4 COMt þ β5 SIZEt þ ε: ð2Þ
All of the explanatory variables in (2) are now subscripted to denote explicitly the temporal relationships. The dependent
variable, AVECHOt+4 is an average of four quarterly charge-off percentages for (future) quarters t+1 through t+4 and is
analogous to the one year-ahead annual charge-off percentage used as the dependent variable by Altamuro and Beatty
(2010).23 Other minor differences are that while we include controls for loan portfolio composition (IND and COM),
we exclude DUNRATE and CSRET from Eq. (2) as the allowance estimates should anticipate future economic conditions based
21
The primary reason for not partitioning on EBP was that any stronger correlations we find between current charge-offs and allowances among
profitable banks could be driven mechanistically by differences in default risk rather than by SAB 102. However, if Strong Banks really do have elevated
default risk, we should also observe higher allowance-NAL associations for those banks since NAL is also a risk indicator (Keeton and Morris, 1987). Thus, it
is not obvious why allowance-AVECHO associations would increase for Strong Banks, but allowance-NAL associations do not. Furthermore, in our
differences-in-difference design, the risk-taking argument applies both before and after SAB 102. Thus, elevated risk-taking among Strong Banks fails to
explain why their allowances should become more highly associated with charge-offs, but not with NAL relative to those of Weak Banks only in periods
after SAB 102 became effective.
22
In Section 5.5, EBP rather than CAPRATIO is used to partition Strong and Weak Banks. We find that the change (decline) in the NAL coefficient for the
Strong Banks was significantly larger than the change for Weak Banks when Periods 4 and 5 are compared with Periods 1 and 2.
23
A justification for using a one-year (four-quarter) horizon for measuring future losses is provided by the Office of the Comptroller of the Currency's
Handbook (1998, p. 13) stating that, “Many Banks consider coverage of one year's losses an appropriate benchmark of an adequate reserve for most pools of
loans. Except in situations discussed below, OCC examiners should generally view this level of coverage as appropriate.”
Table 5
Prediction of Future Charge-offs – Strong and Weak Banks by Capital Ratio (Eq. (2)).
of Periods 4&5 and 1&2
AVECHOt+4 1992–1994 1995–1997 1998–2000 2001–2004 2005–2006 2007–2008
ALLOW 0.075nnn 0.065nnn 0.143nnn 0.202nnn 0.210nnn 0.317nnn 0.136nnn

(8.023) (7.910) (2.948) (4.986) (15.030) (14.004) (4.76)
INDP 0.002nnn 0.005nnn 0.007nnn 0.006nnn 0.003nnn 0.003
(3.429) (6.632) (7.847) (6.460) (7.477) ( 0.777)
COMMP 0.001nn 0.001n 0.001 0.000 0.001nn 0.001
(2.466) (1.826) (1.096) ( 0.856) ( 2.358) ( 1.175)
SIZE 0.000nnn 0.000nnn 0.000 0.000n 0.000nnn 0.000nnn
(3.578) (3.493) (0.714) (1.872) (3.100) (3.567)
Intercept 0.002nnn 0.003nnn 0.003nnn 0.003nnn 0.003nnn 0.006nnn
( 5.392) ( 5.092) ( 6.796) ( 6.217) ( 12.025) ( 8.672)
N 5,080 6,786 7,737 12,706 3,715 3,150

adj. R-sq 0.273 0.304 0.376 0.604 0.785 0.601
Panel B: Weak Banks
ALLOW 0.106nnn 0.064nnn 0.088nnn 0.138nnn 0.063nnn 0.367nnn 0.015

(9.261) (7.570) (8.071) (8.073) (3.875) (8.899) (0.76)
INDP 0.001 0.005nnn 0.004nnn 0.003nnn 0.004nnn 0.001
(0.790) (5.676) (5.740) (7.491) (7.182) ( 1.172)
COMMP 0.002nnn 0.001nnn 0.002nnn 0.001n 0.000 0.002nnn
(4.326) (3.066) (4.223) (1.651) (0.507) ( 4.014)
SIZE 0.000nn 0.000 0.000n 0.000nnn 0.000nnn 0.000n
( 2.486) (1.298) (1.866) (3.965) (4.519) (1.760)
Intercept 0.000 0.001nnn 0.002nnn 0.003nnn 0.002nnn 0.005nn
(0.779) ( 4.207) ( 6.479) ( 9.854) ( 4.572) ( 2.530)
N 5,084 6,791 7,744 12,713 3,720 3,157

adj. R-sq 0.283 0.264 0.204 0.332 0.198 0.419
ALLOW 0.032nn 0.000 0.054 0.065 0.147nnn 0.050 0.122nnn

z-Statistic ( 2.13) (0.01) (1.10) (1.47) (6.84) ( 1.07) (3.51)
Test for significance of difference in R2 between Strong and Weak Banks
Difference 0.009 0.040nnn 0.171nnn 0.272nnn 0.587nnn 0.182nnn

z-Statistic (0.63) (3.01) (14.09) (30.45) (39.85) (10.45)
ALLOW: Allowance at the end of the year scaled by total loans outstanding at the end of the year. Computed as BHCK3123/BHCK2122. AVECHOt+4: Average
of CHO for the four subsequent quarters. CAPRATIO: The end of quarter Total Equity scaled by Total Assets. COM: Commercial Loans as a fraction of Total
Loans. Computed as BHCK1766/BHCK 2122. CHO: Charge offs for the quarter divided by the average loans outstanding for the quarter. Year-to-date charge-
offs are available as data item BHCK4635. IND: Individual Non-Mortgage Loans as a fraction of Total Loans. Computed as BHCK1975/BHCK 2122. Size: The
natural logarithm of Total Assets. STRONG BANKS: Banks in the upper half of each quarter's distribution of CAPRATIO. Total Assets: The end of quarter total
assets of the bank holding company in millions. Available as data item BHCK2170. WEAK BANKS: Banks in the lower half of each quarter's distribution of
CAPRATIO.
n
p o0.1.
nn
p o 0.05.
nnn
p o 0.01.
on information gleaned from current micro and macro-economic sources. Thus, exclusion of these variables facilitates an
evaluation of the ability of loan loss allowances to explain future charge-offs on a stand-alone basis.
In Table 5, we present the forward association tests for allowance informativeness with results for the Strong and
Weak Banks again being presented respectively in Panels A and B. The Strong Bank results in Panel A indicate that the
ALLOW coefficients and R2 values increase over time and are much larger in the Periods 4 and 5 than in Periods 1 and 2. For
example, the average ALLOW coefficient for the Strong Banks changes by 0.136 from Periods 1 and 2 to Periods 4 and 5
(p o.01). In contrast, the ALLOW coefficients and R2 values for the Weak Banks in Panel B do not exhibit the same consistent
increases over time and the average ALLOW coefficient for Periods 4 and 5 is not significantly different from the average for
PERIOD 1 2 3 4 5 6
IND
STRONG-IND 17.3% 16.0% 13.5% 10.3% 6.8% 6.0%
WEAK-IND 15.8% 15.1% 11.9% 8.2% 5.5% 4.9%
COM
STRONG-COM 18.6% 17.4% 17.1% 16.1% 15.5% 15.2%
WEAK-COM 20.3% 20.0% 19.1% 17.2% 15.3% 15.5%
FREAL
STRONG-FREAL 57.6% 61.0% 63.6% 67.6% 73.2% 74.4%
WEAK-FREAL 57.3% 58.7% 62.4% 68.8% 74.6% 74.9%
Fig. 2. (A) Determinants of Allowance – AVECHO and NAL coefficients across Strong and Weak Partitions. The figures below depict the coefficients on
AVECHO and NAL from an estimation of Eq. (1A) without the POST dummy and its interactions for each of the six periods. The figure on the left presents the
estimation results for the Strong Banks and the figure on the right presents the estimation results for the Weak Banks. The full estimation results are also
presented in Table 4. (B) Loan compositions across Strong and Weak Partitions. The figure and table below depict the fractions of non-mortgage loans to
individuals (IND), commercial loans (COM), and real estate loans (FREAL) for the Strong and Weak Banks in the six periods. While the loan compositions do
change significantly over time, the loan composition differences between the Strong and Weak Partitions within periods do not have economic significance.
Periods 1 and 2. The difference-in-differences comparison between the Strong and Weak Banks confirms that the change
in the ALLOW coefficient for the Strong Banks is significantly greater than the change for the Weak Banks (po.01). The R2
values exhibit trends that are similar with trends in the ALLOW coefficients. At the bottom of Table 5, the R2 values for the
Weak and Strong Banks are compared. Note that the differences between the R2 values for the Strong and Weak Banks are
much larger in Periods 4 and 5 relative to Periods 1 and 2 and the very large z-statistics confirm the significance of the
differences in the R2 values for the Strong and Weak Banks. The differences between the Strong Banks and the Weak Banks
are most drastic in Period 5 – just prior to the financial crisis.24 For example, the adjusted R2 is 0.785 for the Strong Banks,
but only 0.198 for the Weak Banks.
Overall, the contrasting informativeness results for the Strong and Weak Banks provide support for H4 Alternative versus
H4. We attribute the improved allowance informativeness for the Strong Banks to stable bank environments that
are consistent with charge-off centric allowance estimation approaches and to SAB 102's ability to constrain excess loss
provisioning. In contrast, the decline in allowance informativeness among the Weak Banks is explained by the challenge of
using charge-offs when banks operate under less stable conditions and the inability of SAB 102 to constrain delayed loss
provisioning by the Weak Banks.25 Finally, the improved results for the Weak Banks in Period 6 are consistent with bank
regulators' recognizing the inherent limitations of charge-offs as a risk indicator in unstable environments and issuing new
regulatory guidance that became effective in December of 2006.
5.5. Loan composition and other robustness tests
We hypothesize and find an inter-temporal shift in both backward and forward allowance associations in response to
SAB 102. Since we have also documented changing loan compositions over time, it is important to ensure that loan
composition changes do not explain the results that we attribute to the SEC's intervention and SAB 102. We have included
loan composition controls, IND and COM, in all our tests. In Table 2, we have also interacted IND and COM with POST
24
Recent empirical evidence by Landier et al. (2010) and Lilienfield-Toal and Mookherjee (2010) suggests that banks had riskier loans well prior to the
onset of the financial crisis in 2007.
25
In un-tabulated tests, we tested the ability of current AVECHO and NAL to explain future losses for the Strong and Weak Banks. The models estimated
for the Strong Banks place more weight on AVECHO and less weight on NAL than do the models estimated for the Weak Banks. These additional results are
consistent with our argument that the Strong Banks are more stable than Weak Banks and that charge-off centric allowance estimation models rely heavily
on stability.
Table 6
Determinants of Allowance – STRONG and WEAK Banks in High IND subsample (Eq. (1A) without the indicator variable).
of Periods 4&5 and 1&2
ALLOW 1992–1994 1995–1997 1998–2000 2001–2004 2005–2006 2007–2008

(7.062) (6.927) (10.035) (25.464) (11.084) (7.323) (4.19)
NAL 0.235nnn 0.196nnn 0.053 0.033nnn 0.024 0.050 0.211nnn
(4.037) (2.708) (1.169) (3.127) ( 0.595) ( 1.459) ( 3.01)
IND 0.009nnn 0.002 0.008nn 0.003 0.007nn 0.001
( 3.051) ( 0.442) ( 2.371) ( 1.074) ( 2.041) ( 0.285)
COMM 0.001 0.006nn 0.000 0.001 0.001 0.004nn
( 0.133) (2.188) ( 0.017) (0.589) (0.617) ( 2.154)
SIZE 0.001nnn 0.001nnn 0.000 0.000 0.000nnn 0.000
(2.937) (2.817) (1.134) ( 0.037) ( 4.479) ( 0.545)
DUNRATE 0.000 0.002nn 0.000 0.001nn 0.000 0.001
( 0.118) (2.091) (0.000) ( 2.219) (0.000) (0.000)
CSRET 0.039nnn 0.010 0.003 0.000 0.011 0.003
(2.634) ( 0.430) (0.000) (0.033) (0.000) ( 0.417)
Intercept 0.007nnn 0.005 0.009nnn 0.011nnn 0.017nnn 0.013nnn
(2.583) (1.470) (4.555) (7.282) (10.448) (3.294)
N 2,696 3,420 4,152 7,102 2,016 1,723

adj. R-sq 0.296 0.249 0.555 0.722 0.880 0.832
Panel B: Weak Banks
AVECHO 1.909nnn 1.852nnn 0.109 1.376nnn 1.916nnn 0.610nnn 0.235

(6.924) (4.870) (0.184) (7.746) (5.822) (4.542) ( 0.57)
NAL 0.191nnn 0.167nnn 0.347nnn 0.138nnn 0.115nnn 0.138nnn 0.053
(6.561) (3.962) (2.957) (5.406) (4.871) (9.585) ( 1.22)
IND 0.007 0.020nn 0.004 0.002 0.005 0.047nn
(0.807) ( 2.511) ( 0.444) (0.262) (0.278) (2.202)
COMM 0.006nnn 0.010nnn 0.011nnn 0.010nnn 0.008nnn 0.009nnn
(3.511) (3.304) (4.137) (4.104) (4.011) (5.062)
SIZE 0.001nn 0.000 0.000 0.000 0.000 0.000
(2.458) (0.607) (0.076) (0.840) ( 1.068) (0.336)
DUNRATE 0.001 0.002 0.001 0.000 0.000 0.000
( 0.668) (1.635) ( 1.205) (0.717) ( 0.303) ( 0.692)
CSRET 0.013 0.010 0.015 0.001 0.006 0.003nnn
(0.000) ( 0.349) ( 1.416) (0.000) (0.000) (20.841)
Intercept 0.002 0.011nnn 0.011nnn 0.009nnn 0.013nnn 0.007
(0.478) (2.964) (3.657) (4.431) (4.718) (1.574)
N 2,384 3,366 3,585 5,604 1,699 1,427

adj. R-sq 0.467 0.228 0.236 0.251 0.250 0.501
t Statistics (z for differences) in parentheses [standard errors adjusted for two way clustering – firm and year]
nnn nnn nnn nnn

AVECHO 0.192 0.231 2.986 1.359 2.025 2.468 1.712nnn
z-Statistic (0.47) ( 0.52) (4.46) (6.55) (4.18) (5.59) (3.15)
NAL 0.044 0.029 0.294nnn 0.105nnn 0.138nnn 0.188nnn 0.158n
z-Statistic (0.68) (0.35) ( 2.34) ( 3.78) ( 2.99) ( 5.07) ( 1.92)
n
p o 0.1.
nn
p o 0.05.
nnn
po 0.01.
Table 7
Determinants of Allowance – STRONG and WEAK Banks in Low IND subsample (Eq. (1A) without the indicator variable).
Dep. Var: ALLOW Period Period 2 Period 3 Period 4 Period 5 Period 6 Difference in averages
1 1992–1994 1995–1997 1998–2000 2001–2004 2005–2006 2007–2008 of Periods 4&5 and 1&2
AVECHO 1.236nnn 0.956nnn 0.842nnn 1.196nnn 0.401 1.555nnn ( 0.298)

(7.936) (10.743) (6.412) (2.941) (1.379) (7.118) ( 0.81)
NAL 0.281nnn 0.270nnn 0.221nnn 0.228nnn 0.170nnn 0.118nnn ( 0.077)
(4.026) (8.060) (10.758) (5.744) (7.360) (15.850) ( 1.27)
IND 0.005nn 0.003 0.002 0.003n 0.002 0.002
( 2.198) ( 1.385) ( 0.650) (1.728) (1.099) (1.428)
COMM 0.002 0.000 0.004nn 0.002n 0.007nnn 0.004nnn
( 0.510) (0.208) (2.420) (1.670) (4.784) (2.710)
SIZE 0.001nnn 0.001nnn 0.000nnn 0.000 0.000 0.000
(6.567) (8.420) (4.516) (1.597) (0.088) (0.616)
DUNRATE 0.002nn 0.003 0.000 0.001nnn 0.000 0.000
(1.998) (1.579) (0.064) ( 2.753) (0.000) (0.000)
CSRET 0.008 0.014 0.002 0.000 0.007 0.008nn
(0.654) ( 0.485) ( 0.494) ( 0.034) (0.000) (2.425)
Intercept 0.002 0.001 0.005nnn 0.006nnn 0.009nnn 0.005
(0.907) ( 0.402) (4.249) (3.164) (4.178) (0.828)
N 2,384 3,366 3,585 5,603 1,699 1,427

adj. R-sq 0.355 0.327 0.333 0.398 0.183 0.505
Panel B: Weak Banks
AVECHO 0.986nnn 1.447nnn 1.072nnn 1.165nnn 1.291nn 0.706nnn (0.011)

(5.425) (6.025) (6.022) (7.649) (2.105) (3.162) (0.03)
NAL 0.286nnn 0.289nnn 0.223nnn 0.144nnn 0.149nn 0.171nnn 0.141nn
(8.524) (6.486) (6.518) (6.801) (2.038) (30.747) ( 2.31)
IND 0.001 0.003 0.005 0.007 0.027nn 0.024
(0.158) (0.415) ( 0.865) ( 1.528) ( 2.199) ( 1.643)
COMM 0.001 0.005n 0.006nnn 0.007nnn 0.005nnn 0.005nnn
(0.747) (1.925) (3.794) (6.147) (4.130) (4.378)
SIZE 0.002nnn 0.001nnn 0.000 0.000 0.001nnn 0.001nnn
(6.115) (3.520) (1.571) ( 0.928) ( 5.314) ( 4.144)
DUNRATE 0.001 0.002 0.001 0.000 0.001 0.002nnn
( 0.750) (1.535) ( 0.807) ( 0.310) (0.000) ( 11.650)
CSRET 0.034 0.003 0.014nnn 0.004 0.001 0.002
( 1.514) ( 0.285) ( 3.975) ( 1.432) (0.000) (1.173)
Intercept 0.013nnn 0.004 0.008nnn 0.012nnn 0.020nnn 0.019nnn
( 3.331) ( 1.247) (4.931) (6.785) (10.612) (7.272)
N 2,700 3,425 4,159 7,110 2,021 1,730

adj. R-sq 0.578 0.391 0.273 0.370 0.260 0.551
n nnn
AVECHO 0.250 0.491 0.230 0.032 0.890 0.849 ( 0.309)
z-Statistic (1.04) ( 1.92) ( 1.04) (0.07) ( 1.31) (2.72) ( 0.54)
NAL 0.004 0.019 0.002 0.084n 0.021 0.053nnn 0.064
z-Statistic ( 0.06) ( 0.34) ( 0.04) (1.87) (0.27) ( 5.77) (0.75)
n
p o 0.1.
nn
p o 0.05.
nnn
po 0.01.
Table 8
Determinants of Allowance – Strong and Weak Banks by profitability (Eq. (1A) without the indicator variable).
Dep. Var: ALLOW Period 1 Period 2 Period 3 Period 4 Period 5 Period 6 Difference in averages
1992–1994 1995–1997 1998–2000 2001–2004 2005–2006 2007–2008 of Periods 4&5 and 1&2

(10.166) (19.462) (7.333) (15.224) (11.079) (7.601) (4.87)
NAL 0.272nnn 0.252nnn 0.248nn 0.067nnn 0.022 0.071nnn 0.217nnn
(13.861) (4.142) (2.278) (3.892) (1.150) (3.936) ( 4.93)
IND 0.004 0.008nnn 0.008nnn 0.001 0.008nnn 0.002
( 1.542) ( 2.986) ( 3.788) ( 0.274) ( 3.342) ( 0.459)
COMM 0.007nnn 0.006nnn 0.003 0.003nnn 0.002n 0.001
(3.844) (2.676) (1.280) (2.856) (1.801) ( 1.239)
SIZE 0.001nnn 0.000nn 0.000nn 0.000nn 0.001nnn 0.000n
(2.951) (2.038) ( 2.268) ( 2.486) ( 5.304) ( 1.691)
DUNRATE 0.001 0.003nn 0.000 0.000 0.000 0.002
( 1.076) (2.234) (0.000) ( 0.639) ( 0.738) (0.000)
CSRET 0.024nn 0.012 0.000 0.000 0.004 0.006
(2.436) ( 0.488) (0.000) (0.616) (0.000) (0.815)
Intercept 0.005nn 0.009nnn 0.014nnn 0.014nnn 0.019nnn 0.016nnn
(2.159) (6.064) (11.737) (12.251) (11.768) (5.052)
N 4,550 5,868 6,799 11,108 3,466 2,611

adj. R-sq 0.275 0.235 0.430 0.683 0.851 0.828
Panel B: Weak Banks

(12.323) (6.665) (6.483) (6.534) (3.021) (7.179) ( 1.22)
(16.338) (9.481) (10.965) (9.978) (4.709) (21.385) ( 2.82)
IND 0.002 0.003nn 0.001 0.000 0.004nn 0.007nnn
( 1.177) ( 1.998) ( 0.487) ( 0.257) (2.089) (3.784)
COMM 0.000 0.005nn 0.005nn 0.006nnn 0.008nnn 0.006nnn
(0.137) (2.460) (2.459) (4.213) (6.863) (3.518)
SIZE 0.001nnn 0.001nnn 0.000nnn 0.000 0.000nnn 0.000
(9.183) (5.174) (3.368) (0.903) ( 3.698) (0.303)
DUNRATE 0.001 0.002 0.001 0.001nn 0.000 0.000nnn
(0.864) (1.452) ( 1.395) ( 2.352) (0.000) ( 3.421)
CSRET 0.007 0.008 0.014nnn 0.007nnn 0.011 0.001
( 0.447) ( 0.357) ( 3.011) ( 2.635) (0.000) (0.939)
Intercept 0.005nnn 0.001 0.006nnn 0.009nnn 0.014nnn 0.007
( 2.641) (0.394) (4.740) (5.798) (10.870) (1.410)
N 5,614 7,709 8,682 14,311 3,969 3,696

adj. R-sq 0.530 0.340 0.258 0.354 0.217 0.506
t Statistics (z for differences) in parentheses [standard errors adjusted for two way clustering – firm and year]
nn nnn nnn nnn nnn

AVECHO 0.424 0.578 2.038 1.454 3.132 2.237 1.792nnn
z-Statistic (2.05) (0.00) (4.79) (5.56) (7.11) (5.20) (4.41)
NAL 0.025 0.007 0.028 0.093nnn 0.131nnn 0.077nnn 0.128nn
z-Statistic (1.00) (0.11) (0.26) ( 3.96) ( 3.47) ( 3.96) ( 2.35)
average of CHO for the current and past three quarters. CHO: Charge offs for the quarter divided by the average loans outstanding for the quarter. Year-to-
date charge-offs are available as data item BHCK4635. COM: Commercial Loans as a fraction of Total Loans. Computed as BHCK1766/BHCK 2122. CSRET: The
return on the Case-Shiller Real estate Index over the quarter. DUNRATE: The change in the unemployment rate from the beginning of the quarter to the end.
IND: Individual Non-Mortgage Loans as a fraction of Total Loans. Computed as BHCK1975/BHCK 2122. NAL: Non-accrual loans at of the end of the quarter
divided by total loans outstanding at the end of the quarter. Size: The natural logarithm of Total Assets. STRONG BANKS: Banks in the upper half of each
quarter's distribution of EBP. Total Assets: The end of quarter total assets of the bank holding company in millions. Available as data item BHCK2170. WEAK
BANKS: Banks in the lower half of each quarter's distribution of EBP
n
p o 0.1.
nn
p o 0.05.
nnn
po 0.01.
to address the possibility that loan composition interacts with period specific macro-economic conditions to explain our
results.26
If changes in loan composition were to explain our cross-sectional results, it would be necessary that loan compositions
differ between the cross-sectional partitions. In Section 4, we described the steps taken to ensure that the size partitions do
not vary significantly in loan composition. Fig. 2B depicts IND and COM loan proportions for the Strong and Weak partitions
across the six periods. While loan proportions are indeed changing over time, the changes occurring within the Strong and
Weak Bank groups appear to be highly consistent. Indeed, one might argue that the loan composition differences in Fig. 2B
are small as compared with the magnitude of the differences in the AVECHO and NAL coefficients that were reported in
Table 4. To generate such changes in AVECHO and NAL coefficients over time from loan composition differences alone, loan
composition differences would need to be at least an order of magnitude larger (as indicated in un-tabulated results).
Furthermore, the sequence of small differences in loan composition does not line-up with the sequence of coefficient
differences in Table 4. For example, the differences in loan composition between the Strong and Weak Banks are smallest in
Period 5, which is also the period with the largest differences in their respective AVECHO and NAL coefficients (see Table 4
and Fig. 2A).
As a further sensitivity analysis for loan composition effects, we partitioned our sample of banks based on the fraction of
non-mortgage loans to individuals (IND) in their loan portfolio. Banks having above (below) the median fraction were placed
in the High IND (Low IND) group. Since IND loans are of the homogeneous type (Liu and Ryan, 1995, 2006) and the guidance
in SAB 102 is more directly applicable to homogeneous loans where losses are estimated at the portfolio level, we expect
that banks having high concentrations of IND loans will be strongly affected by SAB 102. In contrast, banks with
low concentrations of IND loans will be more likely to have larger concentrations of other types of loans in their portfolios
(e.g., commercial and real estate loans). Since these other loan types will be less impacted by SAB 102 guidance than IND
loans, we expect to observe more pronounced contrasts between Strong and Weak Banks in the High IND sub-sample than
in the Low IND sub-sample.27,28 Panels A and B of Table 6 present, respectively, the backward allowance regression results
for the Strong and Weak Banks in the High IND subsample.
Consistent with the preceding arguments, the results presented in Panel A of Table 6 for the High IND sub-sample are
qualitatively similar to those presented in Panel A of Table 4. Specifically, the change in the average AVECHO coefficient for
the Strong Banks in Periods 4 and 5 relative to the average in Periods 1 and 2 is 1.477 and is significant (p o.01). In contrast,
the change in the average AVECHO coefficient for the Weak Banks in Periods during these same periods is 0.235. Thus, the
differences-in-differences comparison indicates that the change in the average AVECHO coefficient for the Strong Banks
is significantly larger than the corresponding change for the Weak Banks. These results provide support for our reasoning
that SAB 102 results should be pronounced for the High-IND banks. Also consistent with Strong Banks' placing significantly
greater emphasis on AVECHO is the finding that they place significantly less emphasis on NAL.29 The difference-in-
26
In the JAE Conference version of this study, we analyze real estate loans (FREAL), IND and COM loans. IND loans are purely homogeneous while COM
loans are purely heterogeneous. FREAL loans are a mixture of homogeneous (residential portion) and heterogeneous loans (commercial portion) that had
significant collateral protection. Ryan and Keeley (R&K), in their discussion of this study, argue that loan compositions shifting towards homogeneous loans
with collateral protection and charge-offs concentrated in IND loans immediately after the SEC’s intervention can potentially explain our results. The two
primary loan composition changes over the time-period of our study are a decrease in IND loans and a increase in FREAL loans primarily driven by the
growth in residential real estate. Contrary to R&K’s loan composition story-line, our analysis showed that the post-intervention allowance-AVECHO
associations were lower for the high FREAL banks than for the low FREAL banks while their NAL associations were higher. Our results also show that
allowance- charge-off associations are indeed significantly higher for banks with a high proportion of IND loans as predicted by R&K. Thus, if IND loans
were to increase over time, R&K’s story-line would provide an alternative explanation for the results attributed to the SEC’s intervention. However, the IND
proportions were actually lower in the periods after the SEC’s intervention. Thus, rather than providing an alternative explanation for increased allowance-
AVECHO associations, the decreasing IND loan proportion actually works against finding increased allowance-AVECHO associations in the later periods
after the SEC’s intervention. We also note that, contrary to R&K’s assertions, IND charge-offs are a smaller fraction of total charge-offs in the period 1998-
2005 than in other periods.
27
Under SFAS 114, losses on heterogeneous loans are measured by valuing loans directly and comparing loan values with book values, rather than by
using historical loss rates. SAB 102 defers to SFAS 114 guidance for measuring losses on heterogeneous loans (see SAB 102 (2001, p. 10) Topic 6:
Interpretations of Accounting Series Releases and Financial Reporting Releases; Response to Question 5 Applying a Systematic Methodology – Measuring
and Documenting Loan Losses under SFAS No. 114). As commercial loans are subject to SFAS 114 accounting guidance, loss allowances are not established
until there is evidence of loan impairment (i.e., borrower has failed to make payments and the liquidation value of collateral is less than the book value of
the loan). For residential real estate loans, banks can establish either general allowances or loan-specific allowances depending on their rating. For
residential real estate loans that are “pass” rated (payments are current and collateral value is adequate), banks establish general allowances for expected
losses at the portfolio level based on SAB 102 guidance. However, when loans lose their pass rating, banks establish loan-specific allowances for expected
losses using the SFAS 114 methodology. Thus, to the extent that commercial and residential real estate loans requiring loan-specific allowances are
prominent in a bank's loan portfolio, the effect of SAB 102 on allowance estimation will be attenuated.
28
R&K’s hypothesis that SAB 102 guidance should have no material impact on homogeneous loans not only fails to recognize that the control
requirements have greater applicability to homogeneous loans (as we have argued in the previous footnote), but also fails to recognize that banks with
larger concentrations of homogeneous loans have a greater ability to overstate allowances by accelerating loan loss provisioning (see Liu and Ryan 2006).
Thus, even if SAB 102 control guidance had equal applicability to homogeneous and heterogeneous loans (contrary to our actual position articulated in the
preceding footnote), we would still expect to observe a larger impact on banks with large concentrations of homogeneous (e.g., IND) loans, due to the
interaction between earnings management and loan composition established previously by Liu and Ryan (2006).
29
Since both R&K’s replication results and our results for IND loans are inconsistent with R&K’s hypothesis of no material effect on homogeneous loans,
R&K conclude that allowance-AVECHO association changes cannot be attributed to SAB 102 and, thus, should instead be attributed to loan composition.
Unfortunately, R&K interpret the inconsistency between their results and story-line as implying that the SEC’s intervention did not have a material effect
differences analysis indicates that the -0.211 change in the average NAL coefficient (for Periods 4 and 5 relative to Periods 1
and 2) for the Strong Banks is significantly more negative than the corresponding -0.053 change for the Weak Banks (p o.1).
In un-tabulated results, we also find that the (forward) associations between current allowances and future losses to be
greater for the Strong Bank partition than for the Weak Bank partition. Thus, allowances remain more informative for the
Strong Banks than for the Weak Banks. These results provide added confidence that the differences in the backward and
forward allowance associations between the Strong and Weak Banks cannot be explained simply by inter-temporal changes
in loan composition.
For the Low IND partition, Table 7 presents the Strong Bank-Weak Bank comparison in Panels A and B, respectively.
In contrast with the results in Table 6 for the High IND partition, the changes in the average AVECHO and NAL coefficients between
Periods 1 and 2 and Periods 4 and 5 are not significant for the Strong Banks. While the average NAL coefficient does decline
significantly for the Weak Banks in Periods 4 and 5 relative to periods 1 and 2, the AVECHO coefficient changes are not significant.
Not surprisingly, the differences-in-differences are not significant for either the AVECHO or NAL coefficients. In fact, with the
exception of Period 6, we do not observe major differences between the Strong and Weak Banks in the Low IND partition. These
findings are along expected lines since SAB 102 is expected to affect Low IND banks less than High IND banks.30
As a final sensitivity test, we now reconsider our reliance on CAPRATIO as a partitioning variable to represent earnings
management incentives of banks. As noted earlier, we employed CAPRATIO to avoid problems that might arise if EBP were to
proxy for risk. However, an argument can be advanced that EBP provides a more direct indicator for earnings smoothing
incentives (Liu and Ryan, 2006; Kanagaretnam et al., 2004). Accordingly, we now replicate the Strong Bank-Weak Bank
comparison employing partitions based on EBP. Our results for the EBP partitions in Table 8 are qualitatively similar to those
reported for the CAPRATIO partitions reported in Table 4 and Fig. 2. Once again, we observe a crossing pattern wherein
Strong Banks with high EBP's exhibit a dramatic decrease in ALLOW–NAL associations, but an increase in their ALLOW-
AVECHO associations. In contrast, Weak Banks do not demonstrate such a pattern in their allowance associations. A
comparison of the average AVECHO coefficient in Periods 1 and 2 with the average in Periods 4 and 5 indicates that the
AVECHO coefficient average for the Strong Banks increases by 1.457 while the coefficient average for the Weak Banks
decreases by 0.336. The differences-in-differences analysis indicates that the AVECHO coefficient changes for the Strong
Banks are significantly greater than the corresponding changes for the Weak Banks (p o.01). Strong Banks' average NAL
coefficients change by -0.217, but the coefficient change is only 0.089 for the Weak Banks. The differences-in-differences
analysis indicates that the decline in the average NAL coefficient is significantly larger in magnitude (po.05) for the Strong
Banks than for the Weak Banks. Both the AVECHO and NAL difference-in-differences results are consistent with H3. Thus, our
results obtained using the EBP partitions are slightly stronger than the earlier results in Table 4 based on CAPRATIO partitions
in that the NAL changes for the Strong Banks are significantly greater than for the Weak Banks.
To ensure that our results are not sensitive to the non-accrual loans (NAL) specification, we performed additional
robustness tests (un-tabulated) using non-performing loans (NPL) as the timely risk measure. As NAL accounts for a very
high percentage of non-performing loans and non-performing assets at most banks, it is not surprising that our cross-
sectional results are similar. As a final robustness test, we modified the cut-off points used for defining the six time periods
by up to four quarters. Our un-tabulated association results for alternative specifications of the time period cut-off points are
similar to those reported previously.
6. Summary and implications
Our results indicate that the SEC's intervention has had effects on banks' allowance estimates that are both economically
meaningful and statistically significant. In the periods after SAB 102/FFIEC (2001) guidance became effective, banks appear
to place more reliance on past charge-offs and less reliance on NAL when estimating their allowances. Perhaps even more
important than the overall effect, however, is our finding that the effects of SAB 102 vary substantially in the cross-section
(footnote continued)
rather than merely that their results were inconsistent with their maintained hypothesis about the intervention’s effects. Consequently, we contend that
R&K’s loan composition results actually help to confirm our position regarding the SEC’s intervention.
30
R&K conduct an “extension” of our paper employing disaggregated (by loan type) NAL and AVECHO as explanatory variables. There is a problem
linking the disaggregated explanatory risk metrics to the aggregated dependent variable when loan composition and defaults by loan type are changing.
Unfortunately, R&K do not indicate how their disaggregated AVECHO and NAL variables are constructed. Assuming that R&K applied our approach by
scaling both charge-off and non-accrual loan components by total loans (rather than by loans of that type), their scaled terms will be sensitive to changes
in the relative size of the loan portfolio and will no longer represent pure risk measures. The irony is that R&K’s scaling will only be immune against this
concern if the percentage of each loan type that is classified as NAL and charge-off rates by loan type were to remain constant over time. However, a
constant loan proportion assumption would be fundamentally inconsistent with R&K’s story-line and their very motivation for conducting the extension in
the first place. Alternatively, it is possible that R&K scaled each disaggregated component only by loans of that type. In such a case, the pure risk
interpretation of each variable will be preserved, but the sum of the two disaggregated measures will not equal our aggregate measure and the estimated
coefficients will again be affected by changes in loan proportions over time as well as changing default rates for each type of loan. R&K want to document
the potential confound in B&N’s results because of changes in loan composition and default rates by loan type. However, under either of the above
scenarios, their tests used to “disprove” our results are themselves sensitive to changing loan compositions and default rates. Finally, we note that their
disaggregated NAL risk measure has a consistently negative and significant association with allowances. Given NAL’s well-established position as a loan
portfolio risk indicator, such a negative and significant association is implausible and, thus, would appear to provide evidence of a misspecification in their
analysis.
based on bank characteristics. We partition banks based on size and financial strength while controlling for loan
composition. We find, consistent with our hypothesis of greater regulatory scrutiny being directed toward large banks by
the SEC, that the allowances of Large Banks are more affected by SAB 102 than those of Small Banks. The allowances of
Strong Banks are also found to become strongly associated with past charge-offs than those of Weak Banks.
Consistent with our finding that SAB 102 had different cross-sectional effects in the backward association test, we also find
evidence of cross-sectional variation in SAB 102's effects on allowance informativeness. In periods after SAB 102/FFIEC (2001)
guidance became effective, we find enhanced allowance informativeness (as proxied by the allowance's ability to explain future
losses) for Strong Banks. We attribute improved allowance informativeness under SAB 102 guidance to its ability to constrain
allowance inflation by Strong Banks and to relatively more stable environments favoring charge-offs as a loss predictor. However,
for Weak Banks, allowance informativeness declines in periods after SAB 102 became effective (especially in Period 5 just prior to
the financial crisis). Two explanations are provided for this decline. First, Weak Banks face less stable conditions (where timelier
risk indicators like NAL would be more appropriate than charge-offs). Second, SAB 102 does not constrain the ability of Weak
Banks to manage earnings by delaying loss provisioning. The informativeness decline for Weak Banks is consistent with the
finding of delays in loss recognition (Dugan, 2009; Beatty and Liao, 2011) that have been alleged to have induced pro-cyclical
lending policies—a factor identified as having exacerbated the financial crisis. We believe that the FFIEC regulators recognized the
potential for misuse of SAB 102/FFIEC (2001) guidance and speculate that these concerns motivated the issuance of the new
Policy Statement that became effective at the end of December 2006.
Appendix A
See Table A1.
Table A1
Variable names and descriptions.
Name Description
ALLOW Allowance at the end of the quarter scaled by total loans outstanding at the end of the quarter. Computed as BHCK3123/BHCK2122.
ALLOWLAG Allowance at the beginning of the quarter.
AVECHO The average of quarterly charge-offs [CHO or CHO (Adj.)] for the current and past three quarters.
AVECHOt+4 The average of quarterly charge-offs [CHO or CHO (Adj.)] for the four subsequent quarters.
CAPRATIO The end of quarter Total Equity scaled by Total Assets.
CHO Charge offs for the quarter divided by the average loans outstanding for the quarter. Year-to-date charge-offs are available as data
item BHCK4635.
CHO (Adj.) Quarterly charge-offs [CHO] adjusted by next quarter's recoveries and scaled by the average loans outstanding for the quarter.
Year-to-date recoveries are available as data item BHCK4605.
COM Commercial Loans as a fraction of Total Loans. Computed as BHCK1766/BHCK 2122.
CSRET The return on the Case-Shiller Real estate Index over the quarter.
DEBP The change in Earnings Before Provisions [EBP] this quarter from the previous quarter.
DNAL The change in non-accrual loans [NAL] from the beginning of the quarter to the end.
DPROV The change in quarterly loan loss provisions [PROV]
DUNRATE The change in the unemployment rate from the beginning of the quarter to the end.
EBP Earnings before provisions computed as the company's earnings after tax plus provisions for the quarter (scaled by lagged Total
Assets). Year-to-date provisions are available as data item BHCK4230.
FREAL Fraction of loans outstanding that are secured by real estate. Computed as BHCK1410/BHCK2122.
IND Individual Non-Mortgage Loans as a fraction of Total Loans. Computed as BHCK1975/BHCK 2122.
LOSS An indicator variable that takes on a value of one if the bank declared a loss for the year and zero otherwise.
NAL Non-accrual loans at of the end of the quarter divided by total loans outstanding at the end of the quarter.
PROFIT An indicator variable that equals one if the company's Earnings Before Provisions [EBP] is in the upper half of the industry wide
distribution for the quarter and zero otherwise.
PROV Loan Loss Provisions for the quarter. Year-to-date provisions are available as data item BHCK 4230.
Size The natural logarithm of Total Assets.
STRONG BANKS Banks in the upper half of each quarter's distribution of CAPRATIO.
Total Assets The end of quarter total assets of the bank holding company in millions. Available as data item BHCK2170.
WEAK BANKS Banks in the lower half of each quarter's distribution of CAPRATIO.
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Journal of Accounting and Economics: Paul J. Beck, Ganapathi S. Narayanamoorthy

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Journal of Accounting and Economics 56 (2013) 42–65

Contents lists available at ScienceDirect

Journal of Accounting and Economics

Did the SEC impact banks' loan loss reserve policies

2.1. Loan portfolio risk metrics

2.2. Loan loss guidance before the SEC's intervention

2.3. The SEC's intervention and response by bank regulators

2.4. SAB 102/FFIEC 2001 policy statement

2.5. New FFIEC policy statement

3.1. Overall effects of SAB 102 guidance

3.2. Bank size effects and allowance associations

3.3. Earnings management incentives and allowance associations

Fig. 1. Time line for regulatory intervention.

4. Sample selection and data

4.1. Sample periods

4.2. Bank data

5.1. Aggregate association tests

Variable Mean Std. dev. Min Max

Panel A: Period 1 (1992–1994) N ¼ 10,164

Total Assets ('000) 3,304,962 13,921,797 20,070 254,246,000

Panel B: Period 2 (1995–1997) N¼ 13,577

Total Assets ('000) 3,991,724 19,830,201 26,618 366,574,000

Panel C: Period 3 (1998–2000) N¼ 15,481

Total Assets ('000) 4,816,162 34,131,698 30,364 902,210,000

Panel D: Period 4 (2001–2004) N ¼25,419

Total Assets ('000) 6,262,300 53,507,530 37,778 1,484,101,000

Variable Mean Std. dev. Min Max

LOSS 0.0121 0.1094 0.0000 1.0000

Panel E: Period 5 (2005–2006) N ¼ 7,435

Total Assets ('000) 11,566,527 88,525,487 61,427 1,884,318,000

Panel F: Period 6 (2007–2008) N ¼ 6,307

Total Assets ('000) 12,577,047 105,825,682 71,152 2,358,266,000

Panel A: Allowance Panel B: Loss Provisions

Unadjusted charge-offs Adjusted charge-offs Provision Model 1 Provision Model 2

AVECHO 1.507nnn 0.489n ALLOWLAG 0.031nnn

ALLOW in (1A), PROV is divided by ending loans receivable:

5.2. Disaggregated analysis of loan loss allowances using bank size

Panel A: Large Banks excluding the top 100 banks

AVECHO 1.602nnn 1.755nnn 2.556nnn 2.594nnn 4.215nnn 3.426nnn 1.726nnn

N 4,180 5,586 6,537 11,106 2,915 2,350

Panel B: Small Banks

AVECHO 1.138nnn 1.200nnn 1.041nn 1.691nnn 1.801nnn 1.376nnn 0.578

N 5,084 6,791 7,744 12,713 3,720 3,157

nnn nn nn nn nnn nnn

Panel A: Strong Banks

AVECHO 1.930nnn 1.827nnn 2.756nnn 2.667nnn 3.897nnn 2.818nnn 1.403nnn

N 5,080 6,786 7,737 12,706 3,715 3,150

Panel B: Weak Banks

AVECHO 1.051nnn 1.256nnn 0.927nnn 1.208nnn 0.815nnn 1.145nnn 0.142

N 5,084 6,791 7,744 12,713 3,720 3,157

nnn nn nnn nnn nnn nnn

5.3. Cross-sectional analysis by bank strength

5.4. Cross-sectional analysis of allowance informativeness

Panel A: Strong Banks

ALLOW 0.075nnn 0.065nnn 0.143nnn 0.202nnn 0.210nnn 0.317nnn 0.136nnn

N 5,080 6,786 7,737 12,706 3,715 3,150

Panel B: Weak Banks

ALLOW 0.106nnn 0.064nnn 0.088nnn 0.138nnn 0.063nnn 0.367nnn 0.015

N 5,084 6,791 7,744 12,713 3,720 3,157

ALLOW 0.032nn 0.000 0.054 0.065 0.147nnn 0.050 0.122nnn

Test for significance of difference in R2 between Strong and Weak Banks

Difference 0.009 0.040nnn 0.171nnn 0.272nnn 0.587nnn 0.182nnn

5.5. Loan composition and other robustness tests