Academic journal article Quarterly Journal of Business and Economics

LDC Write-Off Effects and Bank Stock Returns: The Bank of Boston Decision

Academic journal article Quarterly Journal of Business and Economics

LDC Write-Off Effects and Bank Stock Returns: The Bank of Boston Decision

Article excerpt

LDC Write-Off Effects and Bank Stock Returns: The Bank of Boston Decision

Abstract

This study examines the effect of a publicly announced write-off of LDC loans by the Bank of Boston on December 14, 1987. The stocks of banks with high LDC loan exposure show significant negative abnormal returns the day following the announcement. The stocks of banks with low LDC loan exposure show significant positive abnormal returns the day following the announcement. Cross-sectional regression results of abnormal returns on LDC loan exposure reveal LDC loan exposure to have significant explanatory power the day following the announcement and no other time in the two week window studied, indicating a reevaluation of stock prices based on previously unknown information of LDC loan exposure and policy on LDC loans.

Introduction

Unsecured loans to less developed countries (hereafter LDC loans) are an important part of the loan portfolios of large money-center and regional banks.(1) The effects of such loans on bank stock returns are of interest in academic and financial research. (See, for example, Bennett and Zimmerman (1988), Bruner and Simms (1987), Cornell and Shapiro (1986), McDermott (1988), Musumeci and Sinkey (1988), and Smirlock and Kaufold (1987)].

LDC loans have posed problems for banks since the early 1980s. Large portions of these loans are technically in default. Many of these loans have been

LDC loans have posed problems for banks since the early 1980s. Large portions of these loans are technically in default. Many of these loans have been rescheduled or the government of the country has declared a moratorium on principal and interest payments. In many cases, the loans have been rolled into new loans so that the country would have funds to pay principal and interest on the old loans and thus remain current.

The poor performance of these loans indicates that the loans are worth considerably less than the stated value at which they are carried on the books of the banks and that the chances of collection are slim. Bank managers, however, have been unwilling to write off the loans, write down their reported value, or add sufficient amounts to loan loss reserves to reflect the poor quality of these loans. Moreover, additional loans are made.

There are several reasons for such treatment of LDC loans by bank managers. First, many of the banks have invested heavily in such loans, and the previously stated actions (write-off, write-down, or additions to loan loss reserves) would erode the reported capital of the bank. Second, political pressure has been placed on these banks by the federal government to continue to support these loans (Sinkey (1986)). Reduction of exposure could be construed as a lack of commitment to these countries by the federal government. Third, reduction of exposure would require banks to reduce dividends, shrink, and possibly sell assets (Truell (1987)). Fourth, the banks may prefer not to reveal to the market the extent of their LDC loan exposure. The total amount is not generally known due to varying policies of disclosure (Harris (1988)). An approximate amount is known because banks are required to report LDC loans to individual countries that total over .75 percent of assets. In a money-center bank, however, that is a considerable sum. There is evidence that some banks ignore the .75 percent ruling and report loans only over 1 percent (Harris (1988)). Moreover, not all LDC loans sell at similar discounts on the market, which adds to the confusion. The quality of LDC loan portfolios varies considerably. Finally, it appears that bank examiners have adopted a hands-off policy and have not required banks to act on these loans, regardless of the payment status. Therefore, in practice, little negative action has been taken on these loans (Wall (1988)). As a result, information received by the market is that these loans are ignored. An action taken by banks is seen as an important event. …

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