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Do Banks Recognize Problem Loans Too Slowly? And, Could This Increase the Cyclicality Loan Loss Provisioning?

In this paper I analyze whether banks recognize problem loans loans with substandard and doubtful regulatory risk classifications in a timely manner. I argue that this is important to understand because substandard and doubtful rated loans are loans that should be evaluated for loan loss provisioning on a pooled and individual basis. In the analysis, I examine whether information on corporate loan interest rate spreads at origination and publicly available information on borrower risk forecast future downgrades to substandard and doubtful ratings. The results indicate that origination loan spreads and borrower risk factors forecast future ratings downgrades to substandard and doubtful regulatory risk classifications. I argue that this implies that banks recognize problem loans too slowy and that banks could improve the timeliness of their ratings by fully incorporating available information about borrower risk into their ratings when the information is observed. Furthermore, I find that banks recognize substandard and doubtful rated loans too slowly during business cycle expansions and banks that have has lower earnings and higher provisions in the past year also recognize these loans too slowly. Finally, I find that banks that recognize substandard and doubtful rated loans too slowly also have more cyclical loan loss provisions and allowance for loan and lease losses (ALLL).