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The Potential for Biases in Resolving Loan Problems

Author

Listed:
  • Richard Brody

    (Anderson School of Management, University of New Mexico, Albuquerque, United States)

  • Matias Sokolowski

    (Anderson School of Management, University of New Mexico, Albuquerque, United States)

  • Reilly White

    (Anderson School of Management, University of New Mexico, Albuquerque, United States)

Abstract

This paper describes how behavioral biases influence the resolution of financial covenant violations. Prior literature documents that violation waivers are common; however, there is a lack of discussion on the determinants that lead loan officers to waive covenant violations. We rely on the escalation of commitment bias (or the sunk cost phenomenon) to discuss how loan officers may become attached to a selected course of action and fail to incorporate new information, increasing the likelihood of covenant waivers. We explain the implications of this bias on bank financial reports by detailing how accounting links loan quality to bank financial statements. We further draw on the psychology literature to offer potential solutions to mitigate overcommitment in the context of loan officers. Future research can examine the extent to which loan officers knowingly or unknowingly steer away from rational decision-making. This study has practical implications as users of bank financial reports, including investors, auditors, examiners, and bank managers, learn about processes and challenges on how accounting mechanics link bank loan portfolios to financial statements.

Suggested Citation

  • Richard Brody & Matias Sokolowski & Reilly White, 2021. "The Potential for Biases in Resolving Loan Problems," International Journal of Finance & Banking Studies, Center for the Strategic Studies in Business and Finance, vol. 10(3), pages 57-66, July.
  • Handle: RePEc:rbs:ijfbss:v:10:y:2021:i:3:p:57-66
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    References listed on IDEAS

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