Journal of International Financial Management and Accounting 18:1 2007

Loan Loss Provisions by Banks in Hong Kong, Malaysia and Singapore

Li Li Eng
Oklahoma State University, 700 N. Greenwood Ave, Tulsa, OK 74106, USA e-mail: lilieng@okstate.edu

Sandeep Nabar
Oklahoma State University, 418 Spears School of Business, Stillwater, OK 74078, USA e-mail: sandeep.nabar@okstate.edu

Abstract
This paper studies loan loss disclosures by banks in Hong Kong, Malaysia, and Singapore for the period 1993 through 2000. We nd that unexpected loan loss provisions are positively related to bank stock returns and future cash ows. This indicates that Asian bank managers increase loan loss provisions to signal favorable cash ow prospects, and bank investors bid bank stock prices up when unexpected provisions are positive. These results are consistent with those obtained by Wahlen (1994) for US banks. We also examine the impact of the Asian nancial crisis of 1997 on the loan loss variables. The results indicate that the association between the unexpected loan loss provisions and bank stock returns and future cash ows was signicantly lower in the crisis years, relative to the non-crisis period. Evidently, discretionary loan loss provisions had no signaling value during the crisis. This suggests that macroeconomic uncertainty inuenced the strategic behavior of Asian bank managers and investors.

1. Introduction
This paper examines the behavior of loan loss accounting disclosures of banks in Hong Kong, Malaysia, and Singapore from 1993 through 2000. We also examine the market valuation of the loan loss accounting disclosures, and the association between these disclosures and future bank cash ows. We investigate whether loan loss disclosures reveal bank managers private information about future expected earnings. We also examine whether Asian bank investors view unexpected loan loss provisions to be good news or bad news. Because the time period in this paper encompasses the Asian nancial crisis of July 1997, we also examine the impact of the crisis on the behavior and valuation of loan loss reserves.
We thank two anonymous reviewers, Richard Levich (editor), Sandra Chamberlain, John Eischenseher, Gary Meek, Jim Wahlen, Hao Zhang and seminar participants at the 2004 AAA International Accounting Section midyear meeting (San Diego, CA) and the 2004 CAAA Annual Conference (Vancouver, BC) for their suggestions and Qianhua Ling for her able research assistance.
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We choose to focus on banks in Hong Kong, Malaysia, and Singapore as these countries follow the Anglo-Saxon accounting model, and therefore share similarities in their accounting principles. These three countries were British colonies, and their accounting systems were initially based on the UK model. In 1977, Malaysia and Singapore adopted IAS as the basis for their national accounting standards (Saudagaran and Diga, 1997), and since 1993, Hong Kong standards have been IAS based (Nobes and Parker, 1995, p. 315). Loan loss accounting standards and disclosure requirements in these countries are similar to US practice. The value of loans is stated net of loan loss provisions, with a corresponding charge to the prot and loss accounts. Annual reports also disclose net charge-os and non-performing loans, as in the United States Bank regulation is similar to the United States as well, and a central bank oversees the industry in each country. In Hong Kong, the Hong Kong Monetary Authority is responsible for maintaining monetary and banking stability. A similar role is played by Bank Negara Malaysia in Malaysia, and by the Monetary Authority of Singapore in Singapore. Empirical studies of the US banking industry have obtained mixed evidence of the market reaction to loan loss provisions. Some studies obtain evidence consistent with a positive relation between bank stock returns and loan loss provisions (e.g., Beaver et al., 1989; Johnson, 1989; Elliot et al., 1991; Grin and Wallach, 1991; Beaver and Engel, 1996). These papers conjecture that the market interprets loan loss provisions as signals of bank managers private information about expected future earnings. Wahlen (1994) tests this conjecture, and nds that US bank managers increase the discretionary component of unexpected loan loss provisions when future cash ow prospects improve. Stock returns-based tests conrm that investors interpret discretionary components of unexpected provisions as good news. Extensions of Wahlen (1994) include Liu and Ryan (1995) and Liu et al. (1997). Liu and Ryan (1995) nd that the stock market responds positively to the loan loss provisions of only those banks whose loan portfolios contain a relatively high proportion of large and frequently renegotiated loans (a proxy for the timeliness of the provision). Liu et al. (1997) nd that increased loan loss provisions are good news only in the fourth quarter, for banks that appear at risk of loan default problems. Following the 1990 change in capital adequacy regulations, Ahmed et al. (1999) re-examine the signaling eects of bank loan loss provisions. They analyze a more recent sample of 113 banks over the period 1987 1995 compared with 106 banks over 19771988 in Wahlen (1994).
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Ahmed et al. (1999) obtain results that are contrary to those in Wahlen (1994). Loan loss provisions are signicantly and negatively related to one-year ahead change in earnings, which is inconsistent with the signaling hypothesis. Based on these results, Ahmed et al. (1999) surmise that Wahlens (1994) results are specic to his sample period. Hateld and Lancaster (2000) review several studies examining stock market response to announcements of loss reserve additions, and nd that this evidence is mixed as well. Their analysis of a sample of 121 such announcements over 19801992 indicates that abnormal stock returns (market model prediction errors) are signicantly negative before the event date, but signicantly positive afterwards. This stock price response, however, varies by loan category and time period. A related group of studies examines the determinants of loan loss provisions. These studies have found support for factors such as loan quality and economic conditions (Wetmore and Brick, 1994), bank size, equity capital, and external monitoring (examinations and audits) (Dahl et al., 1998), and asset risk, capital adequacy and pre-loan loss prots (Ahmed et al., 1999). Finally, Kearns (2004) nds that macroeconomic factors such as GDP growth and unemployment rate also inuence loss provisions. These prior results suggest that the behavior and signaling implications of loan loss provisions may vary by time period and by the characteristics of the provisioning banks and their loan portfolios. A natural extension of this research is to investigate the behavior of a sample of banks that not only operate outside the United States, but that also have experienced a signicant economic shock over the sample period. Our paper analyzes loan loss disclosures by banks operating in three Asian economies. We also examine whether the behavior, market valuation, and future cash ow implication of the loan loss disclosures dier between crisis and non-crisis years. The governance and ownership structures of Asian companies are quite dierent from those of US companies. In particular, US corporate ownership is widely dispersed, whereas Asian companies are held closely.1 If these dierences extend to the banking industry, there may be relatively less information asymmetry between Asian bank managers and shareholders. Asian bank managers may therefore face a relatively low demand for private information signals from their shareholders. Ball et al. (2003) argue that Asian rms governance structures cause their managers to produce nancial statements that are less transparent, relative to the US. Less transparent nancial statements may, however, result in greater information asymmetry between managers and outside
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shareholders, leading to an increased demand for signaling. The unique governance and transparency features of Asian rms make them an interesting experimental setting to extend prior US signaling studies. As discussed previously, we also examine loan loss disclosures during the Asian nancial crisis when there was a great deal of uncertainty about the credit-worthiness of outstanding loans. The crisis began with the devaluation of the Thai baht, and quickly spread to other economies in Asia, especially Indonesia, Malaysia, and South Korea. The economies of Asia have close trading ties, and consequently, the nancial centers of Hong Kong and Singapore were not spared the eects of the crisis. As business prots deteriorated, Asian banks saw a corresponding increase in loan defaults. Our sample period allows us to investigate whether the behavior and valuation implications of loan loss provisions dier between crisis and non-crisis years. Our results indicate that unexpected loan loss provisions are positively related with bank stock returns and future cash ows. These results suggest that Asian bank managers use loan loss provisions and Asian bank investors react to these provisions in a fashion similar to that documented by Wahlen (1994) for US banks. We also investigate the impact of the nancial crisis on the relationship between the loan loss variables and bank stock returns and future cash ows, and nd that discretionary provisions had no signaling value during that period. This suggests that environmental uncertainty during the crisis, possibly combined with investors increased focus on fundamentals, led to a change in the strategic behavior of both nancial report preparers and users. Finally, the support for the signaling hypothesis documented here in the Asian context, suggests that Asian managers are responsive to the information needs of outside stakeholders, and may occasionally resort to alternate communication mechanisms to overcome any deciencies of the nancial reporting process. The remainder of this paper is organized as follows. Section 2 contains the research design and the regression models. Section 3 presents the results, and Section 4 concludes.

2. Research Design

2.1 Sample
We obtain our sample from the Worldscope database, which contains nancial statements for banks and bank holding companies in Singapore, Malaysia, and Hong Kong. Our sample period is 1993 through 2000.
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The data coverage for each country is as follows: Singapore 14 subsidiary banks and bank holding companies, Hong Kong 30, and Malaysia 27. We restrict our sample to bank holding companies: Singapore 7, Hong Kong 15, and Malaysia 13. All banks are not covered over the entire sample period, and our preliminary sample contains 205 bank-years. Some banks in this preliminary sample have incomplete data. In our analysis, each test uses all sample observations that have the required data for that specic test. All banks in the sample are commercial banks, providing the full range of banking services. Table 1 presents descriptive statistics for various loan loss variables, scaled by beginning market value of equity, as well as for capital ratios and bank size. Descriptive statistics for the entire sample period (19932000) are shown in panel A, whereas panels B and C report statistics for the crisis (1997 and 1998) and non-crisis years, respectively. The statistics reported in Table 1 underscore the signicance of banks loan portfolios and loan loss provisions. In panel A, mean and median loans outstanding are 7.5 times the market value of equity. Mean (median) non-performing loans are 33.7 per cent (17.7 per cent) of the market value of equity. The mean loan loss allowance is 18.9 per cent of the market value of equity, and is approximately 2.5 times the mean loan loss provision of 7.7 per cent of market value of equity. Mean (median) loan charge os are 6 per cent (2 per cent) of the market value of equity, and the mean non-performing loans amount to 5.5 times the mean charge os. Finally, the mean (median) capital ratio is 19.6 (18) suggesting the banks are adequately capitalized. The results in panels B and C indicate that sample banks experienced relatively large increases in non-performing loans, established relatively high loan loss provisions, and suered signicant declines in protability, during the crisis. While the average values of non-performing loans and loan loss allowance reported in the table are relatively low during the crisis years, these averages reect beginning-of-year balances (consistent with the model variable denitions below), and additional untabulated evidence indicates that the average year-end values of these variables are much higher. For example, mean year-end non-performing loans are 36.4 per cent of the market value of equity during the crisis years, compared with 32 per cent during the non-crisis years. Similarly, mean year-end loan loss allowance is 20 per cent of the market value of equity during the crisis period and 18 per cent otherwise. Finally, while loan charge-os are relatively low during the crisis (panel B), we nd that these write-os peaked in the post-crisis years (12 per cent of the market value of equity in 19992000, not tabulated).
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Loan Loss Provisions by Banks

Table 1. Descriptive Statistics Variables N Mean
0.123 7.557 0.337 0.189 0.077 0.060 0.038 0.315 19.633 15.554

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Median
0.039 7.505 0.177 0.125 0.054 0.020 0.051 0.276 18.000 15.417 0.188 7.472 0.091 0.103 0.100 0.016 0.038 0.255 17.795 15.453 0.003 7.522 0.299 0.144 0.034 0.022 0.081 0.295 18.000 15.417

Standard Deviation
0.337 3.647 0.587 0.205 0.086 0.158 0.176 0.187 8.388 1.305 0.289 3.393 0.168 0.096 0.070 0.031 0.166 0.168 8.436 1.327 0.331 3.774 0.704 0.237 0.090 0.191 0.142 0.194 8.405 1.312

Panel A: all years (19932000) DNPL 113 LoansOut 205 NPL 117 LLA 166 LLP 170 LCO 109 DPreLLE 129 PreLLE 169 CapitalRatio 151 Size 205

Panel B: crisis years (1997 and 1998) DNPL 43 0.276 LoansOut 67 7.414 NPL 44 0.127 LLA 55 0.135 LLP 57 0.102 LCO 36 0.027 DPreLLE 55 0.065 PreLLE 57 0.277 CapitalRatio 48 19.861 Size 67 15.553 Panel C: non-crisis years DNPL 70 LoansOut 138 NPL 73 LLA 111 LLP 113 LCO 73 DPreLLE 74 PreLLE 112 CapitalRatio 103 Size 138 0.030 7.626 0.462 0.215 0.064 0.076 0.114 0.334 19.527 15.554

DNPL equals the change in non-performing loans. LoansOut equals the beginning balance of loans outstanding. NPL equals the beginning balance of non-performing loans. LLA equals the beginning loan loss allowance. LLP equals loan loss provision. LCO equals loan charge os, net of recoveries. PreLLE equals pre-loan loss earnings, and DPreLLE equals the annual change in PreLLE. All preceding variables are scaled by the beginning market value of equity. CapitalRatio equals the banks total capital ratio. Size equals log of total assets measured in US dollars.

2.2 Expectations Models for the Loan Loss Variables

Our methodology for investigating the behavior of the loan loss disclosures is adapted from the approach used by Wahlen (1994), who analyzes three loan loss disclosures: changes in non-performing loans,
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loan loss provisions, and loan charge os (net of recoveries). Wahlen (1994) draws upon loan loss accounting practice to develop and estimate expectations models for each loan loss disclosure. The residuals from these regressions represent the unexpected components of the loan loss disclosures. The expectations models are as follows: DNPLit a0 a1 LoansOutit1 a2 DNPLit1 UDNPLit LLPit b0 b1 LoansOutit1 b2 EDNPLit b3 NPLit1 b4 LLAit1 ULLPit LCOit c0 c1 LoansOutit1 c2 EDNPLit c3 NPLit1 c4 LLAit1 ULCOit 1

where DNPL equals the change in non-performing loans (DNPLit 5 NPLit NPLit 1); LoansOut equals the beginning balance of loans outstanding; LLP equals loan loss provision; EDNPL equals the predicted value of change in non-performing loans from equation (1); NPL equals the beginning balance of non-performing loans; LLA equals the beginning balance in the loan loss allowance account; LCO equals loan charge-os, net of recoveries; UDNPL, ULLP, and ULCO are regression residuals. All explanatory variables are scaled by the beginning market value of equity. We revise the above models as follows. First, virtually all studies that follow Wahlen (1994) (e.g., Ahmed et al., 1999) replace EDNPL in equations (2) and (3) by DNPL. One benet of using DNPL is the increase in the number of observations available to estimate these models. Second, these studies have also identied other factors that inuence the loan loss variables. The factors include capital management (Ahmed et al., 1999), earnings management (e.g., Collins et al., 1995), bank size (Dahl et al., 1998), and macro-economic environment (Kearns, 2004). We incorporate these factors into the models.2 We also incorporate a dummy variable for the crisis years (1997 and 1998) to examine the impact of the crisis on the behavior of the loan loss disclosures.3 Finally, because we pool data from three countries, we include a dummy for Malaysia given the nding in Ball et al. (2003) that legal enforcement and nancial reporting quality are similar in Singapore and Hong Kong (both dragon economies), and that Malaysia (a developing economy) lags these two countries on both dimensions. Our regression models are as follows:
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DNPLit a0 a1 Malaysiait a2 LoansOutit1 a3 DNPLit1 a4 Sizeit a5 GdpGrowthit a6 Crisisit a7 CapitalRatioit a8 PreLLEit UDNPLit LLPit b0 b1 Malaysiait b2 LoansOutit1 b3 NPLit b4 NPLit1 b5 LLAit1 b6 Sizeit b7 GdpGrowthit b8 Crisisit b9 CapitalRatioit b10 PreLLEit ULLPit LCOit c0 c1 Malaysiait c2 LoansOutit1 c3 DNPLit c4 NPLit1 c5 LLAit1 c6 Sizeit c7 GdpGrowthit c8 Crisisit c9 CapitalRatioit c10 PreLLEit ULCOit where Malaysia equals 1 for Malaysian bank-years, and 0 otherwise; Size equals log of total assets measured in US dollars; GdpGrowth equals percentage national GDP growth rate; Crisis equals 1 for the 1997 and 1998 scal years, and 0 otherwise; CapitalRatio is the banks total capital ratio; PreLLE equals pre-loan loss earnings scaled by beginning market value of equity. In these models, Size controls for the possibility that the loan loss variables dier for large and small banks. Similarly, CapitalRatio and PreLLE account for the possibility that rms may adjust their loan losses and provisions in response to capital adequacy and earnings-related considerations. Data on GdpGrowth are obtained from issues of The World Factbook published annually by the Central Intelligence Agency, Washington, DC We also obtain data on unemployment rates, but nd that this variable is negatively correlated with GdpGrowth (Pearsons correlation coecient 0.41, p-valueo.02). The inclusion of unemployment rates as an additional/alternate explanatory variable detracts from the model specications (reduction in signicance levels and adjusted R2s), so we only report estimations with GdpGrowth as the sole macroeconomic environmental factor. The coecients on Crisis capture the dierential behavior of the loan loss disclosures during the scal years impacted by the crisis. If the crisis adversely aected banks loan portfolios, we would expect the banks to record higher non-performing loans, loan loss provisions, and loan charge os than usual. Thus we would expect the coecients on Crisis to be positive and signicant. The inclusion of both Crisis and GdpGrowth in the regression, however, raises a methodological issue, because these variables are negatively correlated (Pearsons correlation
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coecient 0.46, p-valueo.01), given the severe adverse impact of the nancial crisis on the Asian economies. Accordingly, we estimate the following three versions of the expectations models: (a) including GdpGrowth but not Crisis (as an explanatory variable), (b) including Crisis but not GdpGrowth, and, (c) including both Crisis and GdpGrowth.

2.3 The Association between the Loan Loss Variables and Future Cash Flows
Consistent with the conjecture in Beaver et al. (1989); Wahlen (1994) nds that US bank managers increase loan loss provisions when future cash ow prospects improve. Thus the unexpected loan loss provision is positively correlated with future cash ow changes, after controlling for the eects of unexpected change in non-performing loans and unexpected loan charge-os. Because bank cash ow data are not available, and because the loan loss provision is banks most signicant accrual, preloan loss earnings are used as a proxy for cash ows (Wahlen, 1994). The following equation models the relation between future cash ow change and the unexpected components of the loan loss variables: DPreLLEit1 d0 d1 Malaysiait d2 DPreLLEit d3 UDNPLit d4 ULLPit d5 ULCOit d6 Crisisit d7 Crisisit DPreLLEit d8 Crisisit UDNPLit 7 d9 Crisisit ULLPit d10 Crisisit ULCOit eit where DPreLLE equals the change in pre-loan loss earnings, scaled by beginning market value of equity; UDNPL equals the unexpected change in non-performing loans, estimated in equation (4); ULLP equals the unexpected loan loss provision, estimated in equation (5); ULCO equals unexpected net loan charge os, estimated in equation (6); Crisis equals 1 for the 1997 and 1998 scal years, and 0 otherwise. In equation (7), we include Malaysia as a regressor to allow for country eects. The unexpected loan loss variables are obtained from version (a) of the respective expectations models, because in the other versions, a portion of the unexpected loan losses in the crisis years is captured by the coecient on Crisis. If Asian bank managers use loan loss provisions to signal future protability, then we expect a positive
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coecient on ULLP, consistent with the results of Wahlen (1994), and inconsistent with the evidence in Ahmed et al. (1999). The coecient on Crisis captures the dierential behavior of rms cash ow changes in the scal year impacted by the crisis. If the crisis had any adverse lasting eects on the banking business, we would expect the banks to record worse than normal future cash ow growth, and expect a negative estimate of d6. Coecients d8d10 capture the interactions between Crisis and the loan loss disclosure variables. If the crisis aected the relationship between the loan loss variables and future cash ows, then we expect regression (7) to yield signicant estimates for these coecients. As an empirical issue, we assess the eect of including Crisis and the related interactions in the model by estimating a version of equation (7) that excludes these variables.

2.4 The Association between the Loan Loss Variables and Stock Returns
Wahlen (1994) nds that, consistent with the results of his cash ow prediction tests (and with Beaver et al., 1989), investors view unexpected loan loss provisions as good news, after controlling for unexpected changes in non-performing loans and unexpected chargeos. The following equation, similar to those used by Wahlen (1994) and Liu et al. (1997), models the relationship between bank stock returns and the loan loss disclosures: Rit m0 m1 Malaysiait m2 Rmt m3 Sizeit1 m4 PreLLEit m5 UDNPLit m6 ULLPit m7 ULCOit m8 Crisisit m9 Crisisit PreLLEit m10 Crisisit UDNPLit m11 Crisisit ULLPit m12 Crisisit ULCOit vit where R is the stock return from 3 months after the beginning of scal year t through 3 months after the end of scal year t; Rm is the market return measured over the same period as the stock return (the market is the Hang Seng index for Hong Kong banks, the Straits Times index for Singapore banks, and the KLSE composite for Malaysian banks); Size equals log of total assets measured in US dollars; PreLLE equals preloan loss earnings, scaled by beginning market value of equity; UDNPL equals the unexpected change in non-performing loans, estimated in equation (4a); ULLP equals the unexpected loan loss provision, estimated in equation (5a); ULCO equals unexpected net loan charge-os,
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estimated in equation (6a); Crisis equals 1 for the 1997 and 1998 scal years, and 0 otherwise. We add Size as an explanatory variable because the dependent variable is stock returns. The coecient on ULLP captures investors perception of unexpected loan loss provisions. If investors view unexpected loan loss provisions as armative signals of Asian banks future prospects, we expect a signicant positive estimate of m6. The coecient on Crisis measures the impact of the nancial crisis on rms stock returns. Similarly the coecients m10, m11, and m12 allow tests of whether the nancial crisis aected the relationship between stock returns and the loan loss variables.

3. Results

3.1 Determinants of the Loan Loss Variables

Estimation results for the expectations models are presented in Tables 24. As discussed previously, we estimate each model using all observations that have the required data for that specic model. Results are qualitatively similar when we restrict our estimation to a common set of observations that have data for all models. Table 2 presents the results for the three versions of the expectations model for the change in nonperforming loans. The adjusted R2s for these estimations are in the 6668 per cent range. Changes in non-performing loans are negatively serially correlated. In all versions of the model, the coecient on lag change in non-performing loans is negative and signicant at the .001 level. Similarly, the coecient on PreLLE is negative and signicant at the .001 level. Firms with high (low) earnings also experience signicant declines (increases) in nonperforming loans. The coecient on GdpGrowth is negative in version a, but loses its signicance when used in conjunction with Crisis. The coecient on Crisis is positive [po.01 in (4b); po.07 in (4c)]. Evidently, non-performing loans increased signicantly more than average during the crisis years. The results for the loan loss provision model are reported in Table 3, and all versions of the model yield similar coecient estimates and signicance levels. Loan loss provisions are positively related to beginning loans outstanding, and also positively related to the change in nonperforming loans. This suggests that rms increase their provisions in response to an increase in credit risk. The coecient on Size is negative
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Loan Loss Provisions by Banks

Table 2. Determinants of Changes in Non-Performing Loans DNPLit a0 a1 Malaysiait a2 LoansOutit1 a3 DNPLit1 a4 Sizeit a5 GdpGrowthit a6 Crisisit 4 a7 CapitalRatioit a8 PreLLEit UDNPLit

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Variables
Intercept Malaysiait LoansOutit 1 DNPLit 1 Sizeit GdpGrowthit Crisisit CapitalRatioit PreLLEit Adjusted R2 (%)
nnn,nn,n

(4a) Coecient (t-statistic)

0.9289n (2.18) 0.3071nnn (4.05) 0.0431nn (2.75) 0.5074nnn ( 6.08) 0.0460 ( 1.77) 0.0108n ( 2.06) 0.0007 ( 0.18) 1.2889nnn ( 7.87) 66.59

(4b) Coecient (t-statistic)

0.7896 (1.86) 0.3297nnn (4.45) 0.0382n (2.45) 0.4201nnn ( 4.68) 0.0387 ( 1.51) 0.1523nn (2.74) 0.0010 ( 0.24) 1.4570nnn ( 9.78) 68.14

(4c) Coecient (t-statistic)

0.7898 (1.85) 0.3243nnn (4.32) 0.0378n (2.41) 0.4304nnn ( 4.67) 0.0377 ( 1.46) 0.0036 ( 0.55) 0.1287 (1.83) 0.0011 ( 0.29) 1.4087nnn ( 8.11) 67.78

signicance at the .001, .01, .05 levels, respectively. The sample size is 71. DNPL equals the change in non-performing loans (DNPLit 5 NPLit NPLit 1). Malaysia equals 1 for Malaysian bank-years, and 0 otherwise. LoansOut equals the beginning balance of loans outstanding. Size equals log of total assets measured in US dollars. GdpGrowth equals the percentage national GDP growth rate. Crisis equals 1 for the1997 and 1998 scal years, and 0 otherwise. CapitalRatio is the banks total capital ratio. PreLLE equals pre-loan loss earnings. DNPL, LoansOut, and PreLLE are scaled by the beginning market value of equity. UDNPL is the regression residual.

and signicant at the .01 level, suggesting that large banks make relatively small provisions. The insignicant coecient on Crisis suggests that the crisis did not impact the provisioning strategy of the banks, after controlling for the other determinants of provisions (especially the change in non-performing loans, which Table 2 indicates were higher during the crisis years). The coecient on CapitalRatio is positive and signicant at the .001 level in all versions of the model. This is similar to the result obtained by
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Table 3. Determinants of Loan Loss Provisions LLPit b0 b1 Malaysiait b2 LoansOutit1 b3 DNPLit b4 NPLit1 b5 LLAit1 b6 Sizeit b7 GdpGrowthit b8 Crisisit 5 b9 CapitalRatioit b10 PreLLEit ULLPit

Variables
Intercept Malaysiait LoansOutit 1 DNPLit NPLit 1 LLAit 1 Sizeit GdpGrowthit Crisisit CapitalRatioit PreLLEit Adjusted R2 (%)
nnn,nn

(5a) Coecient (t-statistic)

0.0929 (1.03) 0.0463nn (2.76) 0.0240nnn (6.53) 0.0895nnn (4.19) 0.0509 (1.48) 0.0121 (0.12) 0.0140nn ( 2.69) 0.0023 ( 1.94) 0.0036nnn (4.12) 0.2371nnn ( 5.62) 77.75

(5b) Coecient (t-statistic)

0.1099 (1.20) 0.0488nn (2.88) 0.0251nnn (6.83) 0.0878nnn (3.89) 0.0511 (1.46) 0.0076 (0.07) 0.0161nn ( 3.12) 0.0117 (1.02) 0.0038nnn (4.28) 0.2661nnn ( 6.39) 77.05

(5c) Coecient (t-statistic)

0.0931 (1.02) 0.0463nn (2.74) 0.0240nnn (6.49) 0.0891nnn (3.99) 0.0511 (1.47) 0.0117 (0.11) 0.0141nn ( 2.67) 0.0023 ( 1.62) 0.0008 (0.06) 0.0036nnn (4.09) 0.2380nnn ( 5.32) 77.49

signicance at the .001, .01 levels, respectively. The sample size is 95. LLP equals loan loss provision. Malaysia equals 1 for Malaysian bank-years, and 0 otherwise. LoansOut equals the beginning balance of loans outstanding. DNPL equals the change in non-performing loans. NPL equals the beginning balance of non-performing loans. LLA equals the beginning balance in the loan loss allowance account. Size equals log of total assets measured in US dollars. GdpGrowth equals the percentage national GDP growth rate. Crisis equals 1 for the 1997 and 1998 scal years, and 0 otherwise. CapitalRatio is the banks total capital ratio. PreLLE equals pre-loan loss earnings. LLP, LoansOut, DNPL, NPL, LLA, and PreLLE are scaled by the beginning market value of equity. ULLP is the regression residual.

Collins et al. (1995), and indicates that banks with high (low) capital increase (decrease) discretionary loan loss provisions. The coecient on PreLLE is negative and signicant at the .001 level. This suggests that banks with relatively high pre-loan loss earnings are likely to report relatively low loan loss provisions. Thus these banks do not seem to use
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Loan Loss Provisions by Banks

Table 4. Determinants of Net Loan Chargeos

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LCOit c0 c1 Malaysiait c2 LoansOutit1 c3 DNPLit c4 NPLit1 c5 LLAit1 c6 Sizeit c7 GdpGrowthit c8 Crisisit 6 c9 CapitalRatioit c10 PreLLEit ULCOit

Variables
Intercept Malaysiait LoansOutit 1 DNPLit NPLit 1 LLAit 1 Sizeit GdpGrowthit Crisisit CapitalRatioit PreLLEit Adjusted R2 (%)
nnn,nn,n

(6a) Coecient (t-statistic)

0.0325 ( 0.39) 0.0444nn ( 2.67) 0.0007 ( 0.20) 0.0310 ( 1.55) 0.1690nnn (5.25) 0.3534nnn (3.48) 0.0012 (0.24) 0.0025n ( 2.34) 0.0002 (0.21) 0.0081 (0.21) 95.85

(6b) Coecient (t-statistic)

0.0299 ( 0.35) 0.0403n ( 2.37) 0.0002 (0.05) 0.0335 ( 1.61) 0.1755nnn (5.30) 0.3364nn (3.23) 0.0001 (0.01) 0.0171 (1.74) 0.0004 (0.42) 0.0221 ( 0.58) 95.70

(6c) Coecient (t-statistic)

0.0343 ( 0.41) 0.0431n ( 2.56) 0.0006 ( 0.16) 0.0335 ( 1.63) 0.1722nnn (5.25) 0.3456nn (3.36) 0.0011 (0.22) 0.0021 ( 1.64) 0.0070 (0.61) 0.0002 (0.24) 0.0010 (0.03) 95.81

signicance at the .001, .01, .05 levels, respectively. The sample size is 74. LCO equals loan charge os, net of recoveries. Malaysia equals 1 for Malaysian bank-years, and 0 otherwise. LoansOut equals the beginning balance of loans outstanding. DNPL equals the change in nonperforming loans. NPL equals the beginning balance of non-performing loans. LLA equals the beginning balance in the loan loss allowance account. Size equals log of total assets measured in US dollars. GdpGrowth equals the percentage national GDP growth rate. Crisis equals 1 for the 1997 and 1998 scal years, and 0 otherwise. CapitalRatio is the banks total capital ratio. PreLLE equals pre-loan loss earnings. LCO, LoansOut, DNPL, NPL, LLA and PreLLE are scaled by the beginning market value of equity. ULCO is the regression residual.

loan loss provisions for income smoothing. Additional analysis (separate coecients for PreLLE above and below the sample median, not reported) indicates that this result is not specic to banks earning high or low prots. This result, together with the negative coecient on PreLLE in the DNPL model (Table 2), suggests that Asian bank
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managers view current protability to be a positive indicator of the quality of their loan portfolios, and provide for loan losses accordingly. Results for the loan charge-os model estimations are presented in Table 4. The model has signicant explanatory power, and the adjusted R2 exceeds 95 per cent in all versions. Loan charge-os are signicantly positively related with beginning non-performing loans, and beginning loan loss allowance. Malaysian banks charge o fewer loans than banks in Hong Kong and Singapore. The coecient on GdpGrowth suggests that charge-os increase when the economy deteriorates. While the coecient on Crisis is positive, it is not statistically signicant at conventional levels. Hence we cannot conclude that loan charge os were signicantly higher than average during the crisis.

3.2 Estimation of the Cash Flow Prediction Model

We use equation (7) to model the relationship between the loan loss variables and future cash ows. Estimation results for the two versions of this equation (with and without Crisis and related interactions as regressors) are presented in Table 5. Because the dependent and independent variables require three consecutive years of data for each observation, the sample size is reduced to 44. However, both versions of the model have signicant explanatory power, as evidenced by the high adjusted R2s. The coecient on current DPreLLE is insignicant in the both versions of the model. We investigate this unusual result and nd that it is driven by 2 years, 1997 (in which cash ow declines followed prior cash ow increases), and 1999 (in which cash ow increases followed moderate cash ow declines). When we exclude the eect of these 2 years, the coecient on current DPreLLE (not tabulated) is positive and signicant at the .01 level. Notably, the coecient on ULLP, unexpected loan loss provision, is positive and signicant at the .01 level. Wahlen (1994) nds that US bank managers increase loan loss provisions when they expect improvements in future cash ows. The evidence in Table 5 indicates that this behavior applies to Asian bank managers as well. Asian bank managers also appear to use loan loss provisions to signal future protability prospects. The addition of Crisis and related interactions enhances the explanatory power of the model considerably. When we include these additional variables, the adjusted R2 of the model increases from 42.65 to 72.26 per cent. The negative coecient on Crisis indicates that banks cash ows were adversely aected by the crisis. The coecient on
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Loan Loss Provisions by Banks

Table 5. Association between Loan Loss Variables and Future Change in Pre-Loan Loss Earnings DPreLLEit1 d0 d1 Malaysiait d2 DPreLLEit d3 UDNPLit d4 ULLPit d5 ULCOit d6 Crisisit 7 d7 Crisisit DPreLLEit d8 Crisisit UDNPLit d9 Crisisit ULLPit d10 Crisisit ULCOit eit

33

Variables
Intercept Malaysiait DPreLLEit UDNPLit ULLPit ULCOit Crisisit Crisisit DPreLLEit Crisisit UDNPLit Crisisit ULLPit Crisisit ULCOit Adjusted R2 (%)
nnn,nn,n

(7a) Coecient (t-statistic)

0.0110 ( 0.41) 0.3603nnn (4.31) 0.0269 ( 0.33) 0.3827n ( 2.16) 2.0214nn (2.80) 0.6161 ( 0.82)

(7b) Coecient (t-statistic)

0.0691n (2.50) 0.2441nnn (3.65) 0.0873 (1.34) 0.1856 (1.04) 2.7188nn (3.55) 0.6494 (0.72) 0.1473nnn ( 3.69) 0.5435 ( 1.80) 0.7803n ( 2.49) 2.2323 ( 1.76) 0.5788 ( 0.49) 72.26

42.65

signicance at the .001, .01, .05 levels, respectively. The sample size is 44. DPreLLE equals the change in pre-loan loss earnings, scaled by beginning market value of equity. Malaysia equals 1 for Malaysian bank-years, and 0 otherwise. UDNPL equals the unexpected change in non-performing loans, estimated in equation (4). ULLP equals the unexpected loan loss provision, estimated in equation (5). ULCO equals unexpected net loan charge-os, estimated in equation (6). Crisis equals 1 for the 1997 and 1998 scal years, and 0 otherwise. e is the regression residual.

Crisis ULLP is negative (p-value o0.08), indicating that the association between unexpected provisions and future cash ows was signicantly lower during the crisis, relative to the non-crisis years. Moreover the sum of the coecients on ULLP and Crisis ULLP (not tabulated)
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is not signicantly dierent from zero (F-value 0.17, po0.69), suggesting that discretionary loan loss provisions had no signaling value during the crisis. Thus the strategic reporting behavior of Asian bank managers seems to have changed during the crisis. An increase in the levels of scrutiny and monitoring by regulators and auditors may have constrained managerial discretion. Finally the coecient on Crisis UDNPL is negative, suggesting that unexpected increases in non-performing loans during the crisis were followed by cash ow declines in subsequent years.

3.3 Association between Stock Returns and the Loan Loss Variables
We use equation (8) to estimate the relationship between bank stock returns and the unexpected loan loss variables. Table 6 reports regression results for the two versions of this equation. The table indicates that Malaysian banks earned higher stock returns during the test period, relative to the banks in Hong Kong and Singapore. Asian banks, on average, have a beta of considerably less than one. There is no evidence that bank size aects stock returns. The coecient on PreLLE is positive and signicant at the .001 level, indicating that Asian bank earnings are value-relevant. The coecients on the loan loss variables indicate that stock returns are negatively associated with the unexpected loan charge-os, perhaps because investors use this variable to assess credit risk. Banks stock returns are positively associated with unexpected loan loss provisions (coecient estimate 5.7931, t-statistic 3.99, p-value o.001), consistent with the signaling value of these provisions for future cash ows documented in Table 5. This result implies that Asian bank investors recognize the signals in discretionary loan loss provisions and respond accordingly. Healy and Wahlen (1999) speculate that this result may be attributable to negative stock returns earned by rms with abnormally low provisions. They suggest that investors may view abnormally low provisions as an attempt by bank managers to manage current earnings upwards. We investigate this possibility by re-estimating equation (8) with separate coecients for high (above sample median) and low (below sample median) unexpected provisions. Contrary to Healy and Wahlens (1999) conjecture, we obtain (results not tabulated) a signicant positive coecient for high discretionary provisions (estimate 7.2957, p-value o.001) and an insignicant coecient on low discretionary provisions (estimate 3.2842, p-value o0.40).4 These results support the inference that investors in Asian banks view positive unexpected loan loss
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Loan Loss Provisions by Banks

Table 6. Association between Loan Loss Variables and Stock Returns Rit m0 m1 Malaysiait m2 Rmt m3 Sizeit1 m4 PreLLEit m5 UDNPLit m6 ULLPit m7 ULCOit m8 Crisisit m9 Crisisit PreLLEit m10 Crisisit UDNPLit m11 Crisisit ULLPit m12 Crisisit ULCOit vit 8

35

Variables
Intercept Malaysiait Rm Sizeit 1 PreLLEit UDNPLit ULLPit ULCOit Crisisit Crisisit PreLLEit Crisisit UDNPLit Crisisit ULLPit Crisisit ULCOit Adjusted R2 (%)
nnn,nn,n

(8a) Coecient (t-statistic)

0.2074 ( 0.21) 0.6440nnn (4.54) 0.2784 (1.71) 0.0114 ( 0.21) 1.0401nnn (3.89) 0.4496 ( 1.57) 5.7931nnn (3.99) 5.2351nn ( 3.49)

(8b) Coecient (t-statistic)

0.9538 ( 0.99) 0.5635nnn (4.10) 0.2722 (1.73) 0.0313 (0.59) 1.0553nnn (3.81) 0.3412 ( 1.18) 7.1430nnn (4.47) 5.6088nn ( 3.12) 0.5204n ( 2.13) 1.6812 (2.04) 0.7992 ( 0.91) 8.8741n ( 2.56) 0.9764 (0.37) 68.84

62.03

signicance at the .001, .01, and .05 levels, respectively. The sample size is 67. R is the stock return from three months after the beginning of scal year t through 3 months after the end of scal year t. Malaysia equals 1 for Malaysian bank-years, and 0 otherwise. Rm is the market return measured over the same period as the stock return (the market is the Hang Seng index for Hong Kong banks, the Straits Times index for Singapore banks, and the KLSE composite for Malaysian banks). Size equals log of total assets measured in US dollars. PreLLE equals pre-loan loss earnings, scaled by beginning market value of equity. UDNPL equals the unexpected change in non-performing loans, estimated in equation (4). ULLP equals the unexpected loan loss provision, estimated in equation (5). ULCO equals unexpected net loan chargeos, estimated in equation (6). Crisis equals 1 for the 1997 and 1998 scal years, and 0 otherwise. v is the regression residual.
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provisions as good news, because these provisions are indicative of banks favorable cash ow prospects. The second column of Table 6 reports estimation results for the equation (8) version that includes Crisis and related interactions as regressors. These additional regressors again enhance the models explanatory power, although the increase in adjusted R2 (from 62 per cent for version a to 69 per cent for version b) is relatively modest. The estimated coecient for Crisis is negative, indicating that the sample banks suered a signicant decline in their equity values as a result of the crisis. The coecient on Crisis ULLP is signicantly negative, suggesting that the association between discretionary provisions and banks stock returns declined during the crisis. The sum of the coecients on ULLP and Crisis ULLP (not tabulated) is not signicantly dierent from zero (F-value 0.32, po.57). Thus investors appear to have recognized that discretionary provisions lacked predictive ability for future cash ows during the crisis.

4. Conclusion
In this study, we examine the behavior of loan loss disclosures by banks in Hong Kong, Malaysia, and Singapore. We also examine how the unexpected components of the loan loss variables relate to bank stock returns and future cash ows. Our results indicate that banks unexpected loan loss provisions are positively associated with future cash ows and stock returns. The evidence suggests that Asian bank managers increase loan loss provisions when future cash ow prospects improve. Asian bank investors correctly interpret this signal and react accordingly, bidding bank stock prices higher when unexpected provisions are positive. These results are similar to those obtained by Wahlen (1994) for a sample of US banks. Our sample period (19932000) encompasses the Asian nancial crisis of 1997, and we also investigate the impact of the crisis on the behavior of the loan loss variables and their association with returns and future cash ows. We nd that Asian banks experienced a signicant increase in nonperforming loans during the crisis. We also nd that the crisis led to a signicant decline in the relationship between loan loss provisions and bank stock returns and cash ows. Discretionary provisions had no signaling value during the crisis, perhaps due to the uncertain future faced by these banks during that period. These results suggest that the nancial crisis inuenced the strategic behavior of Asian bank managers and investors.
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Loan Loss Provisions by Banks

37

The support for the signaling hypothesis documented here suggests that Asian managers are mindful of the information needs of outside stakeholders. While prior researchers (Ball et al., 2003) have argued that Asian nancial reports are less transparent relative to those issued by US rms, our results imply that Asian managers may occasionally resort to other communication mechanisms to overcome any deciency in the external reporting process.

Notes
1. La Porta et al. (1999) report that 80 per cent of US companies are widely held and 20 per cent are family held. In contrast, 10 per cent of companies in Hong Kong are widely held, 70 per cent family-held, 5 per cent State-controlled and 5 per cent held by nancial institutions. Fifteen per cent of companies in Singapore are widely held, 30 per cent family-held, 45 per cent State-controlled, 5 per cent held by nancial institutions and 5 per cent held by other corporations. Claessens et al. (2000) report that 10.3 per cent of companies in Malaysia are widely held, 67.2 per cent family-held, 13.4 per cent State-held, 2.3 per cent held by nancial institutions, and 6.7 per cent held by other corporations. 2. Other variables likely to inuence the loan loss variables include external monitoring (Dahl et al., 1998), and asset risk measured by credit ratings or the implied volatility of assets (Ahmed et al., 1999). These variables are not included in our models for the following reasons. We do not have data on monitoring by bank examiners or credit ratings. We collect auditor data, but nd that with the exception of three Malaysian banks, all sample rms are audited by the Big-6. We do not have daily stock returns to compute implied asset volatility. We compute asset variance using average leverage and the variance of monthly stock returns (Christie, 1982), but lose over half our sample observations due to the lack of these data. The asset variance variable is insignicant in the regressions, and the loss of power aects the other estimates as well. We choose to exclude this variable from our analysis. 3. The Asian nancial crisis developed in 1997. The evidence of Lemmon and Lins (2003) indicates that the crisis ended in August 1998. 4. We similarly reestimate the DPreLLE [future cash ow change, equation (7)] model. The regression yields a signicant positive estimate for high discretionary provisions and a negative (similar to Ahmed et al., 1999) but statistically insignicant estimate for low discretionary provisions.

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