Timely loss recognition, screening incentives, and lending

This study shows that the switch to the expected loss model (ELM) can curb banks' incentives to screen new loans and incorporate the information obtained in the lending decision. While the information generated in the screening process improves lending quality, under the ELM, it can be integral to the calculation of expected losses. As the recognition of impairments is typically costly for banks, they have incentives to reduce screening, thereby limiting information production and consequently minimizing loss recognition. Moreover, in certain situations, banks may choose not to incorporate the information available in their lending decisions. This strategic decision is aimed at increasing the chances of concealing the signal and avoiding its use in loss recognition. Reduced incentives to produce and use information can negatively impact both the risk and volume of lending. The paper also discusses that strict enforcement of the ELM can mitigate or even reverse the negative incentive effects.