Could An Expected-Loss Reserve Model Have Prevented Bank Failures? – The Empirical Evidence

Tyzz Yun Chen


The current incurred-loss model for loan-loss allowance (“reserve”) accounting has been blamed
globally to be in part responsible for bank failures. The standard setters have exposed
expected-loss models for reserve accounting. A bank’s reserve behavior may be influenced by
regulatory capital requirements, since reserves are counted as Tier 2 capital. However, the cap
on reserves counted in Tier 2 capital may create a disincentive for banks.
The central theme of this paper is to explore whether an expected-loss model would have
prevented bank failures and an increase of the cap on reserves would provide incentive for banks
to build up more reserves.
All else being equal, if the increase of reserves resulting from an expected-loss model in good
times could not cover the losses of banks’ capital in bad years, then an expected-loss model could
not have prevented bank failures. Two years preceding bank failures is the cut-off point
between good years and bad years. During good years, almost all banks were considered to be
well-capitalized, and most had stable capital ratios which stood within a narrow range above the
minimum threshold to be considered well-capitalized.
This paper presents evidence from failed banks, and concludes that an expected-loss model could
not have prevented banks from failing. Moreover, banks’ capital targets are judgmental and
may play a role in influencing banks’ reserve accounting. This paper also finds that an increase
in the permissible reserve level will likely only incentivize 14% of the sample banks to put aside
more reserves.

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