Market reaction to increased loan loss reserves at money-center banks
✍ Scribed by Jeff Madura; Wm. R. McDaniel
- Publisher
- Springer
- Year
- 1989
- Tongue
- English
- Weight
- 634 KB
- Volume
- 3
- Category
- Article
- ISSN
- 0920-8550
No coin nor oath required. For personal study only.
✦ Synopsis
On May 19, 1987, Citicorp announced (after markets closed) that it would add $3 billion to its loan loss reserve in recognition of the poor quality of outstanding loans to Third World countries. Eleven other money-center banks followed this policy over the next five months. The reported reactions of politicians, economists, and market analysts to the increased loan loss reserves varied from despair to praise. Nevertheless, the important issue is the investor's reaction as evidenced by changes in the market prices of the banks' stock. This article uses an event study methodology to shed some light on the issue.
The first section of this article discusses possible reactions to Citicorp's announcements of increased loan loss reserves. The second section describes the formulation and results of the event study methodology as applied to stock prices of money-center banks that adjusted their loan loss reserves. Thc third section draws implications based on the empirical analysis, including some plausible signalling and agency interpretations.
1. Possible reactions to the announcement
A number of analysts, quoted in the popular financial press, 1 believed that a negative market reaction to the increased loan loss reserve should occur. Investors may have not known the extent of the problems with foreign loans. Under this line of reasoning, the announcement would convey a strong negative message to the market, causing negative residuals for the announcing banks.
An alternate reason for expecting a negative reaction is that the announcements would indicate that banks had conceded that payments would not be made. This might reduce the debtor nations' incentive to pursue policies that could enhance the ability to repay principal and interest in the future.
Our thanks to Richard Fosberg and two anonymous reviewers for helpful comments and suggestions. Any errors are our responsibility.