The Potential for Biases in Resolving Loan Problems

Authors

  • Richard Brody
  • Matias Sokolowski University of New Mexico
  • Reilly White

DOI:

https://doi.org/10.20525/ijfbs.v10i3.1312

Keywords:

behavioral biases, escalation of commitment, financial covenant violations, covenant waivers

Abstract

This paper describes how behavioral biases influence the resolution of financial covenant violations. Prior literature documents that violation waivers are common; however, there is a lack of discussion on the determinants that lead loan officers to waive covenant violations. We rely on the escalation of commitment bias (or the sunk cost phenomenon) to discuss how loan officers may become attached to a selected course of action and fail to incorporate new information, increasing the likelihood of covenant waivers. We explain the implications of this bias on bank financial reports by detailing how accounting links loan quality to bank financial statements. We further draw on the psychology literature to offer potential solutions to mitigate overcommitment in the context of loan officers. Future research can examine the extent to which loan officers knowingly or unknowingly steer away from rational decision-making. This study has practical implications as users of bank financial reports, including investors, auditors, examiners, and bank managers, learn about processes and challenges on how accounting mechanics link bank loan portfolios to financial statements.

References

Acharya, V., Almeida, H., Ippolito, F., & Orive, A. P. (2020). Bank lines of credit as contingent liquidity: Covenant violations and their implications. Journal of Financial Intermediation, 44, 100817. https://doi.org/10.1016/j.jfi.2019.03.004

Ao, M., Bao, J., & Kolasinski, A. C. (2019). How Does Lender Health Affect Covenant-Violating Borrowers? https://dx.doi.org/10.2139/ssrn.3413860

Beatty, A., & Liao, S. (2014). Financial accounting in the banking industry: A review of the empirical literature. Journal of Accounting and Economics, 58(2-3), 339-383. https://doi.org/10.1016/j.jacceco.2014.08.009

Bebchuk, L. A., & Jackson, Jr, R. (2005). Executive pensions. https://doi.org/10.3386/w11907

Behr, P., Drexler, A., Gropp, R., & Guettler, A. (2020). Financial incentives and loan officer behavior: Multitasking and allocation of effort under an incomplete contract. Journal of Financial and Quantitative Analysis, 55(4), 1243-1267. https://doi.org/10.1017/S0022109019000334

Berg, T., Puri, M., & Rocholl, J. (2020). Loan officer incentives, internal rating models, and default rates. Review of Finance, 24(3), 529-578. https://doi.org/10.1093/rof/rfz018

Berger, A. N., & Udell, G. F. (1998). The economics of small business finance: The roles of private equity and debt markets in the financial growth cycle. Journal of Banking & Finance, 22(6-8), 613-673. https://doi.org/10.1016/S0378-4266(98)00038-7

Berger, A. N., & Udell, G. F. (2002). Small business credit availability and relationship lending: The importance of bank organisational structure. The Economic Journal, 112(477), F32-F53. https://doi.org/10.1111/1468-0297.00682

Brockner, J. (1992). The escalation of commitment to a failing course of action: Toward theoretical progress. Academy of Management Review, 17(1), 39-61. https://doi.org/10.2307/258647

Brody, R. G., & Kaplan, S. E. (1996). Escalation of commitment among internal auditors. Auditing, 15(1), 1.

Chodorow-Reich, G., & Falato, A. (2017). The loan covenant channel: How bank health transmits to the real economy (No. w23879). National Bureau of Economic Research. https://doi.org/10.3386/w23879

Christensen, H. B., & Nikolaev, V. V. (2012). Capital versus performance covenants in debt contracts. Journal of Accounting Research, 50(1), 75-116. https://doi.org/10.1111/j.1475-679X.2011.00432.x

Christensen, H. B., Nikolaev, V. V., & Wittenberg?Moerman, R. (2016). Accounting information in financial contracting: The incomplete contract theory perspective. Journal of Accounting Research, 54(2), 397-435. https://doi.org/10.1111/1475-679X.12108

Christensen, H. B., Macciocchi, D., Morris, A., & Nikolaev, V. V. (2021). Financial Shocks to Lenders and the Composition of Financial Covenants. Journal of Accounting and Economics, 101426. https://doi.org/10.1016/j.jacceco.2021.101426

Demerjian, P., Donovan, J., & Lewis?Western, M. F. (2020). Income smoothing and the usefulness of earnings for monitoring in debt contracting. Contemporary Accounting Research, 37(2), 857-884. https://doi.org/10.1111/1911-3846.12544

Demerjian, P. R., & Owens, E. L. (2016). Measuring the probability of financial covenant violation in private debt contracts. Journal of Accounting and Economics, 61(2-3), 433-447. https://doi.org/10.1016/j.jacceco.2015.11.001

Demerjian, P. R. (2010). Financial covenants, credit risk, and the resolution of uncertainty. Credit Risk, and the Resolution of Uncertainty (February 25, 2010). http://dx.doi.org/10.2139/ssrn.1559232

Demiroglu, C., & James, C. M. (2010). The information content of bank loan covenants. The Review of Financial Studies, 23(10), 3700-3737. https://doi.org/10.1093/rfs/hhq054

Dichev, I. D., & Skinner, D. J. (2002). Large–sample evidence on the debt covenant hypothesis. Journal of Accounting Research, 40(4), 1091-1123. https://doi.org/10.1111/1475-679X.00083

Edmans, A., & Liu, Q. (2011). Inside debt. Review of finance, 15(1), 75-102. https://doi.org/10.1093/rof/rfq008

Eisdorfer, A., Giaccotto, C., & White, R. (2013). Capital structure, executive compensation, and investment efficiency. Journal of Banking & Finance, 37(2), 549-562. https://doi.org/10.1016/j.jbankfin.2012.09.011

Freudenberg, F., Imbierowicz, B., Saunders, A., & Steffen, S. (2017). Covenant violations and dynamic loan contracting. Journal of Corporate Finance, 45, 540-565. https://doi.org/10.1016/j.jcorpfin.2017.05.009

Gustafson, M. T., Ivanov, I. T., & Meisenzahl, R. R. (2021). Bank monitoring: Evidence from syndicated loans. Journal of Financial Economics, 139(2), 452-477. https://doi.org/10.1016/j.jfineco.2020.08.017

HassabElnaby, H. R. (2006). Waiving technical default: The role of agency costs and bank regulations. Journal of Business Finance & Accounting, 33(9?10), 1368-1389. https://doi.org/10.1111/j.1468-5957.2006.00633.x

Jeffrey, C. (1992). The relation of judgment, personal involvement, and experience in the audit of bank loans. Accounting Review, 802-819.

Kalmanovich-Cohen, H., Pearsall, M. J., & Christian, J. S. (2018). The effects of leadership change on team escalation of commitment. The Leadership Quarterly, 29(5), 597-608. https://doi.org/10.1016/j.leaqua.2018.03.004

Kirby, S. L., & Davis, M. A. (1998). A study of escalating commitment in principal–agent relationships: Effects of monitoring and personal responsibility. Journal of Applied Psychology, 83(2), 206. https://doi.org/10.1037/0021-9010.83.2.206

Li, W., & McMahan, P. (2015). A case study on loan loss analysis of a community bank. The Journal of Finance and Data Science, 1(1), 11-32. https://doi.org/10.1016/j.jfds.2015.07.001

Liberti, J. M., & Petersen, M. A. (2019). Information: Hard and soft. Review of Corporate Finance Studies, 8(1), 1-41. https://doi.org/10.1093/rcfs/cfy009

McNamara, G., Moon, H., & Bromiley, P. (2002). Banking on commitment: Intended and unintended consequences of an organization's attempt to attenuate escalation of commitment. Academy of Management Journal, 45(2), 443-452. https://doi.org/10.5465/3069358

Paik, D. G., Hamilton, T., Lee, B. B., & Yoon, S. W. (2019). Loan purpose and accounting based debt covenants. Review of Accounting and Finance. https://doi.org/10.1108/RAF-10-2017-0194

Paik, D. G., Smith, J. V. D. L., Lee, B. B., & Yoon, S. W. (2020). Are leases substitutes or complements to debt? Insights from an analysis of debt covenants. Review of Accounting and Finance. https://doi.org/10.1108/RAF-05-2019-0106

Rodgers, W. (1999). The influences of conflicting information on novices and loan officers' actions. Journal of Economic Psychology, 20(2), 123-145. https://doi.org/10.1016/S0167-4870(99)00002-1

Ruchala, L. V., Hill, J. W., & Dalton, D. (1996). Escalation and the diffusion of responsibility: A commercial lending experiment. Journal of Business Research, 37(1), 15-26. https://doi.org/10.1016/0148-2963(95)00171-9

Freudenberg, F., Imbierowicz, B., Saunders, A., & Steffen, S. (2011). Covenant violations, loan contracting, and default risk of bank borrowers. Working paper.

Staw, B. M. (1981). The escalation of commitment to a course of action. Academy of Management Review, 6(4), 577-587. https://doi.org/10.5465/amr.1981.4285694

Sundaram, R. K., & Yermack, D. L. (2007). Pay me later: Inside debt and its role in managerial compensation. The Journal of Finance, 62(4), 1551-1588. https://doi.org/10.1111/j.1540-6261.2007.01251.x

Treacy, W. F., & Carey, M. (2000). Credit risk rating systems at large US banks. Journal of Banking & Finance, 24(1-2), 167-201. https://doi.org/10.1016/S0378-4266(99)00056-4

Wang, Y., & Xia, H. (2014). Do lenders still monitor when they can securitize loans? The Review of Financial Studies, 27(8), 2354-2391. https://doi.org/10.1093/rfs/hhu006

Downloads

Published

2021-08-14

How to Cite

Brody, R. ., Sokolowski, M., & White, R. . (2021). The Potential for Biases in Resolving Loan Problems. International Journal of Finance & Banking Studies (2147-4486), 10(3), 57–66. https://doi.org/10.20525/ijfbs.v10i3.1312

Issue

Section

Articles