Under Pressure: The Shifting Landscape of Banking Regulations

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Wharton's Allison Nicoletti discusses her research on loan loss provision estimates in banking.

The banking sector is subject to a number of regulations designed to promote the safety and soundness of the industry. Loan loss accounting standards began to change following the 2008 global financial crisis. In her latest research, “The Effects of Auditors and Bank Regulators on Loan Loss Provisions,” Wharton accounting professor Allison Nicoletti analyzes how external auditors and bank regulations affect the discretion that banks have in loan loss provision estimates. She recently spoke with Knowledge@Wharton about her work.

An edited transcript of the conversation follows.

Knowledge@Wharton: You’re going to talk today about your dissertation. Could you give us a broad overview?

Allison Nicoletti: My dissertation examines how external auditors and bank regulators affect loan loss provision decisions. The loan loss provision is analogous to bad debt expense for a non-financial firm, and for banks, it’s one of the most important accruals. It makes up a large part of their income statement and has implications because it’s tied to their loan quality. So, this is a really important decision that banks care about and that the bank regulators and external auditors are concerned with.

There’s a lot of discretion that goes into coming up with the loan loss provision estimate. What’s interesting is that bank regulators are involved in on-site safety and soundness examinations, and external auditors come in and actually audit the financial statements. But these two groups have very different objectives and incentives. Bank regulators are coming at it more from a safety and soundness perspective, whereas auditors are coming at it by asking, “Do the financial statements comply with generally accepted accounting principles?”

“Loan loss accounting standards are changing, and this was a direct result of the financial crisis.”

What I find in my paper is that bank regulators and auditors both seem to increase the timing with which banks recognize loan losses. But at banks where there’s both a strict regulator and an external auditor, these banks are less timely, compared with banks that are unaudited but have a strict regulator. What this seems to suggest is that the auditor is constraining timeliness relative to what the bank regulator would prefer. Again, this is probably tied to the objectives and incentives that they have, where auditors are concerned about earnings management and other discretionary choices that banks might be making that aren’t necessarily tied to loan quality. The regulator is less concerned with that.

Knowledge@Wharton: What are the implications for a bank?

Nicoletti: There are definitely implications for the bank because the bank manager is trying to balance these two potentially opposing viewpoints. You have bank regulators pushing more timeliness versus the auditor, who maybe prefers less timeliness relative to the regulator. That’s one of the takeaways. Bank managers do have to balance that. But more importantly, loan loss accounting standards are changing, and this was a direct result of the financial crisis. One of the concerns with the current rules is that auditors are concerned about the discretion that banks have, and that was why they restricted. They’re concerned that banks are managing earnings or doing other opportunistic things with the accounting.

This was a problem in the financial crisis because the threshold to recognize a loss was very high. We saw banks waiting quite a bit of time before they recognized any losses. The new accounting standards will be more of an expected approach, so banks will be recognizing losses over the life of the loan, but there’s going to be a lot more discretion that goes into that. As far as how this regulator/auditor conflict gets resolved, or actually gets worse under the new accounting standards, is an open question.

Knowledge@Wharton: Are there implications for the average person or a business trying to get a loan?

Nicoletti: There could be some implications as far as the new accounting standards going into play. To the extent that banks are going to have to recognize greater loan losses, that has to hit somewhere on their balance sheet. If it’s coming out of their capital — and there are bank capital requirements — that may result in restricting lending purposes. It could have an effect like that. My research probably can’t speak to that quite as much because I’m looking at a different accounting standard, but it does really just speak more to the bank managers themselves. And then, probably regulators, auditors and groups that are involved in overseeing the audit profession.

Knowledge@Wharton: With bank managers, has there been a historical trend toward what the regulators are looking for versus the auditors? Are there prevailing winds as far as that goes?

“There has been a lot of conflict between the regulator and auditor over the last 20 or 25 years.”

Nicoletti: I think it probably depends, is the short answer. There has been a lot of conflict between the regulator and auditor over the last 20 or 25 years. In the late 1990s, there was a conflict again between the regulators and auditors where it seemed that banks were trending more towards the regulator view, where they were reserving to a great extent for loan losses, even perhaps more than the economics of their loan portfolio would imply. So the Securities and Exchange Commission, a group that’s probably more aligned with the external audit function, was not happy about that because it was basically shifting income between reporting periods.

There was a struggle between the bank regulators and the SEC, and what ended up happening was that the bank regulators and the SEC issued new guidance saying, “This is what you should be doing for loan losses.” So, the SEC ended up winning that battle. But now, following the crisis, it seems that we’re shifting more back to a standard that perhaps regulators would prefer. I think that we’ll probably see banks shifting more back to the regulator view. But they were more in the audit/SEC camp earlier in the decade.

Knowledge@Wharton: What’s next for this research?

Nicoletti: I have a different project that’s still related to bank regulation, but it’s looking at the Dodd-Frank Act. What we’re interested in is looking at specific bright-line asset thresholds. Many bank regulations, and other regulations in general, have these thresholds like $10 billion in total assets, for instance, where above that threshold, banks are subject to significant regulatory costs.

What we’re looking at is whether those bright-line thresholds seem to incentivize merger activity. And if they do, do these mergers have different outcomes relative to other mergers? The preliminary findings of that would suggest that these thresholds do spur additional merger activity, and these mergers that result from these regulatory cost motivations do seem to end up having poorer outcomes relative to other mergers.

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