Improving the Joint Effectiveness of Unexpected Loss and Expected Loss Standards for U.S. Banking Organizations

Capital standards and loan loss reporting standards are deeply interconnected for U.S. domestic and internationally active banking organizations, as both regulate a banking organization’s ability to absorb losses and to maintain solvency. This paper empirically considers their joint effectiveness utilizing different regimes for each standard, different timings for the respective regime changes, and, most importantly, changes in bank behavior over the business cycle in response to such changes. We employ data for (i) large bank holding companies with total assets greater than $10 billion and (ii) U.S. holding companies subject to the Federal Reserve’s tailoring regime to demonstrate that the Current Expected Credit Losses (CECL) standard increased loan loss reserves in normal economic conditions, thereby alleviating the “too little too late” problem associated with the previous loan loss provision standard, but it appears to have not have mitigated the “pro-cyclicality” problem compared to the Incurred Loss standards for its adopters during the COVID pandemic-related recession in 2020. For banking organizations with the strongest loan loss reserve rates, loan loss reserve rates and capital ratios play complementary roles; a one percent increase in the capital ratio makes it less likely for a banking organization to be among those with the strongest loan loss reserve rates. However, for banking organizations with the weakest reserves, more capital may be needed to cover future loan losses; a one percent increase in the capital ratio makes it more, not less, likely for a banking organization to be among those with the weakest loan loss reserve rates. Our consideration of reported loan loss reserve rates in opposite tails of the loan loss rate distributions is consistent with the view that higher capital requirements need not provide higher overall buffers, which include both loan loss reserves and capital, throughout the business cycle to cover loan losses.