How Good was the Incurred Loss Model During the 2008 Financial Crisis

• In Event: Reception with Effective Learning Strategies Displays
  In Poster Session: Poster 3

Abstract

The profitability of bank depends on loan yields, cost of funds, and realized credit risk. The crux of bank accounting is how to measure and disclose ex ante credit risk. The incurred loss model is going to be replaced by the current expected credit loss model in 2020, as International Financial Reporting Standards was already implemented. It has a profound ramification for bank accounting as well as for industrial firms. This paper examines how good the incurred loss model was to disclose the expected credit loss during the 2008 financial crisis. This paper measures the empirical relationship between ex ante credit loss, which is proxied by loan loss provision, and realized credit loss, which is measured by net charge-off. Then the relational parameter is examined before, during, and after the 2008 financial crisis to find the extent and the speed of the changing relationship.
The 2008 financial crisis was one of the biggest crisis that affected firms across industries, including a financial one. It provides a natural laboratory to empirical researchers that a paradigm before the crisis is quite different from that after the crisis. Banks set up loan loss allowance sufficient enough to deal with realized credit losses before the 2008 crisis. The incurred loss model worked until there is a cataclysmic crisis. Once the 2008 crisis reached the full-blown stage and banks scrambled to preserve its capital, credit just disappeared to hurt the economy. This pro-cyclicality is blamed to be caused by the incurred loss model, which will be replaced for its sin. This paper is a post-mortem analysis that examines the incurred loss model before the crisis, during the crisis, and after the crisis.
Would the proposed current expected credit loss model fare better? Only the next crisis will answer. Given the forecasting accuracy of the economic forecasting models on the coming cataclysmic crisis, the credit loss model matter less.

Author

• kwangsoo lim, The Citadel