Does discretionary loan loss provision strengthen or weaken market information efficiency in the banking sector?

We examine whether and how discretionary loan loss provision (DLLP) affects the future earnings response coefficient (FERC) of stock returns among banks. There are long standing debates and mixed findings in the bank accounting literature on whether the DLLP contributes to information signaling or earnings management. To date, however, this literature has not directly evaluated the impact of DLLP on the share price anticipation of banks’ future earnings performance. We provide evidence that DLLP influences the relationship between current stock returns and future earnings among banks in ways consistent with the signaling rather than the earnings management effect. Further analyses reveal this effect is (i) stronger among banks more incentivized to convey favorable future prospects to outside investors, and (ii) independent of the influence of timeliness in loan loss recognition. Our findings imply that the change from incurred to expected loss models could strengthen the market information efficiency among banks.