Research

Working papers

Loan Loss Provisions and Regulatory Capital

Abstract

By requiring forward-looking provisions based on economic forecasts, CECL changed how minimum capital requirements constrain lending, yet minimum capital requirements have not been adjusted in response. This paper studies optimal capital regulation under ILM and CECL and shows that the two regimes call for qualitatively different designs. With time-varying requirements, both regimes can support an efficient allocation, but CECL requires a lower ratio that adjusts over the economic cycle. The sharpest differences arise with constant requirements, where the provisioning model determines not only the optimal level of the requirement but also the types of outcomes that are achievable. Which regime is preferable depends on the consequences of bank failure: when failure risk must be eliminated, ILM dominates; when some failure risk can be tolerated, CECL can dominate through its self-disciplining mechanism, enabling an outcome that has no analogue under ILM. CECL's advantage, however, is not automatic -- it depends on forecasts being informative enough to affect lending while credit risk uncertainty remains. The transition to CECL therefore requires careful recalibration of capital ratios and close attention to the properties of economic forecasts used in provisioning.

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Online appendix

Forward-Looking Loan Loss Provisioning Under Imperfect Forecasts

Dissertation

Awards:

J. Michael Harrison Doctoral Prize for Impactful Contribution to Theory
FASB Emerging Scholar Finalist
Community Banking Research Conference Emerging Scholar Award, sponsored by the Federal Reserve, the Conference of State Bank Supervisors, and the Federal Deposit Insurance Corp

Presentations: Credit Scoring and Credit Control Conference (University of Edinburgh), American Accounting Association Annual Meeting (Poster presentation), Trans-Atlantic Doctoral Conference (LBS), Chicago Booth Workshop

Link to pdf

Abstract

The current expected credit losses (CECL) model stipulates that loan loss provisions should be forward-looking. I document that banks increasingly rely on macroeconomic forecasts following the implementation of CECL, yet most forecasts are not rational. I build a theoretical model to study the implications of CECL for bank provisions, lending, aggregate output in the economy, and bank stability. Additionally, I derive the optimal minimum capital requirement within the CECL framework. I first explore the implications under rational expectations and then consider bank expectations influenced by Kahneman and Tversky's (1972) representativeness heuristic to capture the empirical properties of macroeconomic forecasts. My model demonstrates that the representativeness heuristic results in overreaction to news, leading to underprovisioning, excessive lending and risk-taking in reaction to good news, and the opposite in reaction to bad news. Due to timely loan loss provisioning under CECL, the optimal capital constraint is time-varying in response to the macroeconomic conditions and the underlying risk in the economy. In contrast to rational expectations, the representativeness heuristic necessitates a binding capital constraint even when bank equity is high and the social cost of bank failure is low.

Timely Loan Loss Provisioning and Aggregate Cost of Capital

Abstract

I study the effect of timely loan loss provisioning on banks’ demand for raising capital and the cost to do so. I develop a theoretical model that captures how updates in expected credit losses affect the cost of raising capital when banks violate the minimum capital requirements and need to raise capital ex post. I find that CECL makes the banking system more capitalized in case of a recession, but may lead to a unnecessary capital issuance in the face of negative news. I also study the effect on the bank’s cost of capital when the bank moves away from relying on idiosyncratic information about its loan portfolio towards relying on macroeconomic information. Timely loan loss provisioning and higher reliance on macroeconomic information promotes stability of the banking system. However, as macroeconomic news affects all banks, provisions become more correlated. Reliance on macroeconomic information also leads to spillover effects: bad news from one bank raise the cost of equity issuance of other banks.

Paying for CSR: Firm and Peer Group Effects

(with Maria Khrakovsky)

Abstract

We examine the effects of the inclusion of Corporate Social Responsibility (CSR)-related incentives in executive compensation contracts on firm performance. We build on the findings of prior work by using a larger, more representative sample of public firms and leveraging compensation peer groups to study peer effects. We find that, after adopting CSR-based compensation, firms' CSR performance improves but their financial performance worsens. These effects differ between “leader” and “follower” firms within compensation peer groups and, while “leader” firms do not experience a differential CSR performance effect, they perform better financially compared to “follower” firms. We consider two channels through which CSR-based compensation affects financial performance: through better alignment of incentives or through signaling to stakeholders the firm's commitment to CSR. We find support for both channels.

Misperceived Preferences in Joint Decisions: Evidence from a Field Experiment on Parent-Child School Choice

(with Alexandr Lenk)

Presentations: Advances in Field Experiments Conference, 2023 North American ESA Meeting, Chicago Booth Behavioral Economics Lab

Link to pdf

Online Appendix

Abstract

In many joint decisions-across families, advisorships, and teams-one party often makes a choice that primarily affects another. When the outcome diverges from the beneficiary's preferences, this is often interpreted as a deliberate override. We argue this interpretation is incomplete: the decision maker may also hold inaccurate beliefs about the beneficiary's preferences, effectively reducing the weight of these preferences in the final decision more than intended. We demonstrate this in high-stakes parent-child school choice, a setting with frequent communication where meaningful belief errors might be expected to be limited. We find parents are misinformed about their children's preferred schools and systematically underestimate how much their own preferences differ from those of their children. In a field experiment that transparently reveals children's school rankings, parents shift their children's school applications toward those rankings, including on key margins such as top-choice schools and academic versus vocational tracks. Accounting for belief errors nearly triples the inferred weight parents place on children's preferences. Overall, our findings suggest that improving preference transparency can have important economic consequences for joint and delegated choices.

Work in progress

Breaking the Gender Glass-Ceiling Effect in Managerial Positions: The Role of Multinational Firm Structure and Inter-Branch Competition

(with Alexandr Lenk)

Sources of Overreaction to News in Banks’ Loan Loss Allowances

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