Paying Bank Risk Professionals to Lie About Bank Loan Loss Provisioning Process

Abstract

This paper analyses the effects associated with using the magnitude of realised loan losses as a basis for performance measurement and compensation to credit risk team in banks. Paying and rewarding credit risk professionals on the basis of reporting fewer provisions or lower loan losses motivate credit risk teams to game the system that work to determine loan loss provisions estimate of banks. While bank credit risk teams are sometimes mesmerised by the short-term benefits of provisions games, they do not care if their behaviour destroys bank value and the informativeness of loan loss provisioning estimates. While it is not difficult for bank managers and analysts to understand that the provisioning process is subject to gaming, few of them understand the costs it pose on banks and how to lower this costs. This paper explains how this happens and how provisions games can be stopped or reduced. Using the magnitude of loan losses as a basis to determine the compensation to risk professionals or credit risk teams encourages provisions games. The solution is not to reduce or eliminate provisioning discretion of credit risk teams but rather to de-link credit risk teams’ bonuses from the magnitude of loan loss