Inferring Management Quality at Banks from Accounting Data and its Role in Bank Failures

• In Event: Bank Failures, Systemic Risk, and Financial Stability

Abstract

Loan loss provisions and charge-offs incorporate the private information bank managers
have on the quality of their loan portfolios. We examine the relation between abnormal
loan loss provisions and abnormal charge-offs, and the management component of
CAMELS ratings from bank examinations. We find that banks with higher values for
these accounting measures receive a lower quality rating. Monte Carlo cross-validation
and cross-tabulation robustness tests support our results. Our findings provide evidence
that loan loss provisions and charge-offs measures can be used to evaluate bank managements'
ability to assess the true risk of their loan portfolios. We also provide evidence
that abnormal loan loss provisions and abnormal charge-offs are positively associated
with the risk of bank failure. This result is consistent with the notion that managements'
inadequate understanding of the true risk of their loan portfolios contributes to bank
failure, a view corroborated by the findings of the Material Loss Reviews.

Authors

• Prateek Sharma, Louisiana State University

• Jung Eun "JP" Park, University of Nebraska Omaha