Forward-looking Loan Loss Provisioning Under Imperfect Forecasts
Hristiana Vidinova, Accounting PhD student
The new accounting standards CECL and IFRS 9 stipulate that loan loss provisions should be forward-looking. Expected results from the new accounting standards implicitly rest on the assumption that banks' economic expectations are rational, but the macroeconomic and behavior finance literature finds strong empirical evidence against this hypothesis. I developed a model where banks' macroeconomic expectations are subject to Kahneman and Tversky's (1972) representativeness heuristic to study the implications for bank provisions, lending, and bank stablity. The representativeness heuristic results in overreaction to news: specifically, excessive lending and risk-taking in good times, and overly precautionary lending in the case of negative macroeconomic shocks. The minimum capacity adequacy requirement constrains the effect of excessive optimism, but has no bite on overreaction to news in case of downturns. I test the predictions of the model during the COVID-19 recession by studying the link between banks' macroeconomic forecasts and provisions of CECL-adopting and non-adopting banks.