How to deal with issues arising in the loan loss provisioning process - A case study of a large Swedish bank

Sammanfattning: By conducting a case study on a Swedish bank, we aim at filling the gap in previous research and increasing the understanding about loan loss provisioning, by identifying issues that arise during the loan loss provisioning process. We show that three main issues arise during the process: (1) how to design the internal guidelines to achieve a consistent process, (2) how to consistently identify and handle when to take a provision, and (3) how to estimate the size of provision. The process is based on the accounting standard IAS 39, but additionally the Bank sets specific internal rules. Furthermore, consistency is created by the use of internal controls, which we analyze based on a two- dimensional framework by modifying Simon's (1995) four levers of control by adding an additional dimension; to what degree the control system is founded on a rules- or a principles-based regime. We found that the Bank's rules-based system makes the Bank focus on diagnostic controls and boundary systems. Furthermore, our study shows that earnings management can occur internally, as empowered relationship managers have incentives to manipulate the input used for the diagnostic control system, and that the Bank aims to mitigate this issue by using separation of powers. We conclude that the process is complex and involves difficult subjective measurement issues. The incurred loss model of IAS 39 is backward-looking and it is evident that management judgment has a large impact when estimating the size of the provision.