The effect of commercial banks' internal control weaknesses on loan loss reserves and provisions

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Abstract

This study examines whether the material internal control weaknesses (ICW) of commercial banks affect loan loss reserves and provisions. Bank regulators have been keen to improve the internal control procedures of banks in order to obtain accurate estimates of loan loss exposures. GAO, 1991, GAO, 1994 reports that loan-loss reserves are often determined based on historical loss rates even for large loans, rather than individual loan impairment assessments, and the reported loan loss reserves include substantial amounts of supplemental reserves that are not linked to the loan loss exposure. We expect and find that banks with material ICW have, on average, higher loan loss reserves and provisions in years of ICW than those without ICW. We also find that ICW banks with successful remedial actions no longer have higher levels of loan loss reserves or provisions in the next year, while banks that report material ICW in both the current and following year continue to have significantly higher amounts of loan loss reserves and provisions in the next year.

Introduction

The effectiveness of banks' internal control has been under the scrutiny of regulators since as early as 1991.1 GAO reports of 1991 and 1994 document that many failed banks had inaccurate loan loss reserves and provisions due to poor internal control procedures, distorting their financial statements. Loan loss reserves are the estimated amount of the bank's loss exposure to cover uncollectible outstanding impaired loans. Loan loss provisions are an expense necessary to adjust the loan loss reserves. Loan loss reserves are the single largest component of bank accruals, and commercial bank loan portfolios are typically ten to fifteen times larger than their equity (Altamuro, Beatty, 2010, Wahlen, 1994). Therefore, loan loss reserves and provisions provide critical information about credit risk exposures to the clients and investors of banks. In line with regulatory attention to internal control effectiveness and its relation to loan loss reserves, we investigate whether material internal control weaknesses (ICW) are systematically associated with loan loss reserves and provisions of banks, and whether the following remedial actions affect them in the year after the material ICW report.

After a number of banks failed in the 1980s, the Federal Deposit Insurance Corporation (FDIC) passed the Federal Deposit Insurance Improvement Act (FDICIA) in 1991, requiring that the management of banks with more than $500 million in assets evaluate the effectiveness of their internal controls processes of financial reporting and that the banks' external auditors attest to the effectiveness of the banks' internal control structure. However, banks continued to suffer from internal control problems related to corporate governance and financial reporting, and rocked the financial markets again in the early 2000s, resulting in a significant loss of investor confidence in U.S. businesses and auditing firms.2 To regain investors' trust, the Securities and Exchange Commission (SEC) enacted the Sarbanes–Oxley Act (SOX) in 2002, imposing stricter corporate governance measures on not only banks but also all other public firms with assets greater than $75 million. In particular, Section 404 (b) of the SOX requires public firms to evaluate and report on the effectiveness of their internal control attested by independent auditors, and as a result the ICW data have become readily available. More recently, the Federal Reserve has performed a sweeping review of its bank supervision on internal control and how much loan loss reserves banks must maintain, after the 2007–2008 financial crisis (Ryan, 2014). As a result, the Dodd–Frank Wall Street Reform and Consumer Protection Act has been enacted in 2010.

Although there is a dearth of accounting studies on internal control issues and loan loss estimation among banks, Altamuro and Beatty (2010) investigate whether the internal control regulations of the FDCIA improve the validity of loan loss provisions. They compare banks affected by the FDCIA with total assets greater than $500 million to banks unaffected by the regulation. However, it is possible that some banks with total assets greater than $500 million do not have material ICW. Our study extends Altamuro and Beatty (2010) by comparing loan loss estimates between the banks that actually report material ICW and those with no ICW in order to understand the role of material ICW in loan loss estimation. Therefore, our study connects the current literature on ICW with the existing literature on loans loss.

One line of ICW literature focuses on the impact of ICW on the cost of capital (Ashbaugh-Skaife et al, 2009, Beneish et al, 2008, Hammersley et al, 2008, Kim et al, 2011, Ogneva et al, 2007). Ogneva et al. (2007) find no significant relationship between ICW and the cost of equity. Ashbaugh-Skaife et al. (2009), however, report that ICW increases the cost of capital and that the cost of capital significantly decreases after remedial actions for ICW. Another line of ICW literature investigates characteristics of ICW firms (Ashbaugh-Skaife et al, 2009, Chan et al, 2008, Doyle et al, 2007, Ge, McVay, 2005, Krishnan, Visvanathan, 2007).3 ICW firms tend to be younger, less profitable, and in the midst of rapid growth. They tend to have more complex operations, recent changes in organizational structure, more accounting risk exposure, fewer resources, or a lower return–earnings relationship, compared to their counterparts.

Prior studies on loan loss reserves usually focus on bank managers' incentives to use loan loss estimation. Loan loss reserves may be used in income smoothing (Ahmed et al, 1999, Kanagaretnam et al, 2003, Kanagaretnam et al, 2004, Kilic et al, 2013). When earnings are poor, managers can draw down the allowances for loan loss to reduce loan loss provisions and, as a result, increase earnings. Chen et al. (2005) document that determinants of loan loss reserves include nonperforming loans, loan interest rates, and loan loss charge-offs. However, they do not look into the quality of the loan loss review process and the resulting ICW reports as another determinant. To investigate these aspects, we posit that banks with material ICW have lower quality internal loan loss review processes than their counterpart.

Banks have to follow the Statement of Financial Accounting Standards (SFAS) No. 114 Accounting by Creditors for Impairment of a Loan and the SFAS No. 5 Accounting for Contingencies for their loan loss estimations (Chen et al., 2005). The SFAS No. 114 requires that banks determine which loans are impaired and assess the degree of impairment according to their internal evaluation process. The SFAS No. 5 provides the fundamental recognition criteria for loan losses. Due to the diversity and subjectivity of internal loan loss evaluation methods, the reported loan loss reserves and provisions often lack reliability, tainting the transparency of financial statements of banks. In our first hypothesis, we investigate whether banks with material ICW are more likely to misrepresent loan loss reserves and provisions.

Regulators believe that banks need to use individual loan assessments especially for large impaired loans (GAO, 1994). A high quality internal control system is imperative for accurate estimation of loan loss exposure, as individual loan assessments require an in-depth understanding of loan payment history, collaterals, and other relevant information. However, banks commonly use historical loss rates to evaluate loan loss risk and often keep excessive supplemental reserves. Supplemental reserves are set aside in addition to the reserves that are estimated from the loan loss assessment, and they are used to avoid negative reserves adjustments, appease regulators, or follow historical loss rates (GAO, 1994).4 Unjustified supplemental reserves can be used to manage earnings and distort future loan loss estimation, resulting in more room for error and manipulation.5 Thus, we expect that banks with material ICW tend to misrepresent their loan loss estimates and have excessive supplement reserves. It is because they have less pressure to provide legitimate justifications of the estimates and excessive reserves.6 In order to test the first hypothesis, we compare loan loss reserves and provisions between banks with material ICW and banks without ICW. We construct our matching samples based on firm size and return on assets for each year. We find that banks with material ICW indeed have significantly greater amounts of loan loss reserves and provisions than the control sample. Our results remain robust even after controlling for the self-selection bias and endogeneity.

An alternative explanation of the greater loan loss reserves and provisions among ICW banks is private information signaling. Prior studies report that banks use loan loss reserves and provisions to signal private information about positive future prospects (Beaver, Engel, 1996, Kanagaretnam et al, 2004, Kanagaretnam et al, 2005, Kanagaretnam et al, 2009, Wahlen, 1994). However, Ahmed et al. (1999) does not find private information signaling among banks. We investigate whether material ICW plays a significant role in the banks' decision to signal private information via loan loss estimates. If ICW banks increase loan loss estimates to signal good news about future earnings, they would most likely enjoy better future earnings performances. Thus, we divide our sample of ICW banks into two groups with high loan loss reserves (or provisions) and low loan loss reserves (or provisions) and compare the future earnings performance of the two groups. We do not find a significant difference in future earnings performances of the two groups, contrary to the signaling scenario.

In the second hypothesis, we investigate whether the excessive loan loss reserves would decrease in the following year of ICW due to remedial actions. If banks with material ICW take successful remedial actions and improve their internal control procedures and measurements of operating activities, we expect the excessive loan loss reserves to disappear in the next year. To test the second hypothesis, we compare loan loss reserves and provisions between banks with material ICW and banks without ICW in the year following the ICW reports. As expected, our results show that there is no significant difference in loan loss reserves and provisions between the two groups. However, it is possible that not all banks succeed in improving their ICW problems in the following year. Thus, we divide our test sample into (1) banks with material ICW in the current year but no ICW in the next year and (2) banks with material ICW in both the current and following years and construct the matching samples for the two groups separately. We find that loan loss reserves and provisions of the banks that succeed in remedying ICW are not significantly different from those of their counterparts in the next year. On the contrary, the banks that report material ICW in both years continue to have significantly greater loan loss reserves and provisions in the next year.

The remainder of this paper is organized as follows: Section 2 presents hypothesis development, Section 3 describes our research design, and Section 4 discusses our data and empirical results with sensitivity tests. We present our conclusion in Section 5.

Section snippets

Hypotheses development

Banks often pursue new lending opportunities with unfamiliar risks, especially when margins are under pressure.7 Therefore, bank regulators have continuously endeavored to ensure high quality internal control procedures among banks for adequate amounts of loan loss

Research design

Our first hypothesis investigates whether banks with material ICW have more loan loss reserves and provisions than their counterparts. To test this hypothesis, we use the following regression model:LLRtorLLPt=α0+α1ICWt+α2NIMt+α3NPATt+α4ROAt+α5SIZEt+tα6,tFYt+εt

  • where LLRt = loan loss reserves in year t, as a percentage of total loans;

  • LLPt = loan loss provisions in year t, as a percentage of total loans;

  • ICWt = an indicator variable of material internal control weakness in year t, set as 1 if

Data

Our pooled sample consists of 8167 firm-year observations of banks (SIC codes 6000–6189) with non-missing variables of material ICW (data item: COUNT_WEAK) in the AuditAnalytics database and loan losses reserves (data item: RLL) and loan loss provisions (data item: PLL) in the Compustat database for years 2002–2013. We exclude observations with missing values of total loans (data item: LNTAL), nonperforming assets (data item: NPAT), net interest margin (data item: NIM), income before

Conclusion

This study examines whether the internal control effectiveness of commercial banks affects their loan loss reserves and provisions. The credit risk exposure of banks is reflected in loan loss reserves and thus loan loss provisions, and inaccurate loan loss estimates can serve as a tool for fraudulent conduct by bank management. We expect and find that firms with ICW tend to have inflated loan loss reserves and provisions, indicating that internal control effectiveness is an important factor of

Acknowledgements

The authors would like to thank Samir El-Gazzar, Donald Kent, and Dan Simunic (the editor), the anonymous referee and the seminar participants at the 2015 American Accounting Association Northeast Regional Meetings for their comments. The financial support of the Lubin School of Business of the Pace University is gratefully acknowledged.

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