Discretionary loan loss provisioning and stock trading liquidity

Loan loss provisioning is a key bank accounting practice that directly influences banks’ earnings and reflects the risk attributes of banks’ loan portfolios. Bank managers can record a loan loss provision that deviates from one that is notionally correct in order to obscure information on banks’ performance and riskiness, thus elevating information uncertainty among investors. The difference between an observed loan loss provision and a notionally correct loan loss provision is referred to as an unexpected or discretionary loan loss provision (“DLLP”). Banks associated with DLLP, and other opportunistic accounting practices, are said to be financially opaque. Theory suggests that opacity in financial reporting can lead to reduced levels of stock trading liquidity. In this study, we examine whether DLLP is correlated with firm opacity features as reflected in the stock market. Using data from US public banks, we find that, banks associated with a higher level of accumulated DLLP, are more likely to experience reduced stock trading liquidity. These findings confirm the notion that DLLP reduce firms’ financial information quality, leading to greater firm opacity, which in turn negatively affects banks’ stock trading liquidity. Reduced stock trading liquidity imposes costs on banks, and therefore on banks’ stakeholders, sometimes simply because DLLPs cater to the self-interest of those making the decision to use them. The policy implication is that observed use of DLLPs ought to motivate a regulatory response in the form of increased regulatory attention to banks where use of DLLPs is evident.