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Paying Bank Risk Professionals to Lie About Bank Loan Loss Provisioning Process

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  • Ozili, Peterson K
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    This paper analyses the effects associated with using the magnitude of realised loan losses as a basis for performance measurement and compensation to credit risk team in banks. Paying and rewarding credit risk professionals on the basis of reporting fewer provisions or lower loan losses motivate credit risk teams to game the system that work to determine loan loss provisions estimate of banks. While bank credit risk teams are sometimes mesmerised by the short-term benefits of provisions games, they do not care if their behaviour destroys bank value and the informativeness of loan loss provisioning estimates. While it is not difficult for bank managers and analysts to understand that the provisioning process is subject to gaming, few of them understand the costs it pose on banks and how to lower this costs. This paper explains how this happens and how provisions games can be stopped or reduced. Using the magnitude of loan losses as a basis to determine the compensation to risk professionals or credit risk teams encourages provisions games. The solution is not to reduce or eliminate provisioning discretion of credit risk teams but rather to de-link credit risk teams’ bonuses from the magnitude of loan loss.

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    File URL: https://mpra.ub.uni-muenchen.de/75354/1/MPRA_paper_75354.pdf
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    File URL: https://mpra.ub.uni-muenchen.de/75637/1/MPRA_paper_75354.pdf
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    Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 75354.

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    Date of creation: 30 Nov 2017
    Handle: RePEc:pra:mprapa:75354
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    1. Daniel Perez & Vicente Salas-Fumas & Jesus Saurina, 2008. "Earnings and Capital Management in Alternative Loan Loss Provision Regulatory Regimes," European Accounting Review, Taylor & Francis Journals, vol. 17(3), pages 423-445.
    2. Laeven, Luc & Majnoni, Giovanni, 2003. "Loan loss provisioning and economic slowdowns: too much, too late?," Journal of Financial Intermediation, Elsevier, vol. 12(2), pages 178-197, April.
    3. Ellen Gaston & In W Song, 2014. "Supervisory Roles in Loan Loss Provisioning in Countries Implementing IFRS," IMF Working Papers 14/170, International Monetary Fund.
    4. Beatty, Anne & Liao, Scott, 2011. "Do delays in expected loss recognition affect banks' willingness to lend?," Journal of Accounting and Economics, Elsevier, vol. 52(1), pages 1-20, June.
    5. Ahmed, Anwer S. & Takeda, Carolyn & Thomas, Shawn, 1999. "Bank loan loss provisions: a reexamination of capital management, earnings management and signaling effects," Journal of Accounting and Economics, Elsevier, vol. 28(1), pages 1-25, November.
    6. Ozili, Peterson K, 2015. "Loan Loss Provisioning, Income Smoothing, Signaling, Capital Management and Procyclicality: Does IFRS Matter? Empirical Evidence from Nigeria," MPRA Paper 68350, University Library of Munich, Germany.
    7. Sarawan Angklomkliew & Jason George & Frank Packer, 2009. "Issues and developments in loan loss provisioning: the case of Asia," BIS Quarterly Review, Bank for International Settlements, December.
    8. Robert M. Bushman & Christopher D. Williams, 2015. "Delayed Expected Loss Recognition and the Risk Profile of Banks," Journal of Accounting Research, Wiley Blackwell, vol. 53(3), pages 511-553, 06.
    9. Michael C. Jensen, 2003. "Paying People to Lie: the Truth about the Budgeting Process," European Financial Management, European Financial Management Association, vol. 9(3), pages 379-406.
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