I provide evidence that loan loss accounting affects procyclical lending through its impact on regulatory actions. Regulators are more likely to place banks with inadequate loan loss allowances under enforcement actions that restrict lending, leading these banks to lend less during downturns. Further, I find that banks with lower regulatory ratings lend less when they have more timely provisions, consistent with research theorizing that timely provisions increase transparency and inhibit regulatory forbearance. This regulatory action mechanism expands on prior research that has focused on the effect of loan loss recognition on regulatory capital adequacy during economic downturns.

ABSTRACT Accounting for credit losses under U.S. GAAP is transitioning from an incurred to an expected loss model. The model change was motivated by concerns that reporting only incurred losses does not provide investors with sufficient and timely information about banks’ credit risk. In this paper, I develop a measure of lifetime expected credit losses using vintage analysis to examine whether stock prices reflect information about unrecognized expected credit losses in an incurred loss regime. Consistent with investors being able to obtain information about expected losses that are not recognized in the financial statements, I find that unrecognized expected credit losses are negatively associated with bank stock prices. The pricing of these losses is stronger for larger banks, consistent with lower costs of obtaining this information for banks with better information environments. I also find that recorded allowances were less than estimated expected losses, on average, consistent with concerns that implementing the expected loss model will adversely impact regulatory capital adequacy.

Discretionary income smoothing has been argued to increase bank opacity and degrade financial system stability by making banks more difficult to monitor. However, no direct empirical association between discretionary smoothing and opacity has been established to date. We argue that smoothing could reflect either the opportunistic exercise of discretion that disconnects loan loss provisions (LLPs) from changes in underlying credit quality, consistent with smoothing increasing opacity, or an informative exercise of discretion to communicate forward‐looking information about loan losses. We examine the association between discretionary smoothing and the informativeness of LLPs for a sample of banks from 1994 to 2019 and find that discretionary smoothing is, on average, associated with more informative LLPs. However, this association is nuanced, with cross‐sectional differences and changes over time. We find evidence that an intervention by the SEC into bank LLP practices in the late 1990s curbed opportunistic smoothing via provisioning for homogeneous loans. Subsequently, smoothing is associated with more informative provisions, including for banks with both more homogeneous and more heterogeneous loan portfolios. Our findings are inconsistent with the notion that smoothing may be associated with greater opacity.