Does uncertainty matter for loan charge-offs?

Laetitia Lepetit, Frank Strobel and David Dickinson

Research Conference on Safety and Efficiency of the Financial System, Manila

August 27, 2007

2

Objective

• analysis of loan charge-off behavior of banks– non-performing loans need to be charged off

– behavior has discretionary elements, e.g. management of regulatory capital

– consider additional element related to uncertainty about economic environment

• build theoretical model and perform empirical analysis

3

Theoretical model

• develop stylized real options model of bank's decision whether or not to charge off a currently non-performing loan when– there is chance of full loan recovery

– expected present value of reinvesting potentially reclaimed collateral is uncertain

• demonstrate that bank proves less willing to charge off non-performing loan than in classical certainty case

4

Theoretical model (cont.)

• increased uncertainty about and trend in expected value of collateral increases bank's tendency to delay loan charge-off

• better general economic conditions, increasing the probability of loan recovery, reduce bank's willingness to delay loan charge-off

banks have discretionary behavior regarding loan charge-offs related to variability in market for collateral and general economic conditions

5

Empirical analysis

• test this hypothesis of "uncertainty management" in loan charge-offs

• use a panel of European commercial, savings and cooperative banks over the period 1992 to 2005

• estimate the following equation using GMM

1 1 2 3

4

log( ) 3it it it it it it

it i it

NCO NCO X GDP R M M

H

6

Eq.

(Obs) it 1

( )

NCO

it

( )

NPL

it 1

( )

LOANS

it

( )

TCR

it

(?)

LOG(TA) it

( )

M

it

( )

H

it

( )

log(GDP)

it

( )

R3M

J-stat (P-

value)

Arellano and Bover (1995) estimator

(2.1) (552)

0.090*** (140.651)

0.063*** (42.169)

0.004*** (42.413)

_ _ -0.014*** (-103.057)

-0.006*** (-7.792)

0.067*** (36.479)

0.032*** (38.980)

41.489 (0.45)

(2.2) (552)

0.111*** (137.582)

0.062*** (68.586)

0.004*** (33.238)

_ 0.562*** (72.010)

-0.018*** (-79.389)

-0.009*** (-11.043)

0.095*** (29.067)

0.070*** (72.798)

41.781 (0.35)

(2.3) (506)

0.091*** (4.467)

0.065*** (5.151)

_ 0.014 (1.048)

_ -0.006*** (-3.955)

-0.002* (-1.814)

0.036*** (2.593)

0.062*** (7.397)

30.405 (0.44)

Empirical analysis (cont.)