The Potential for Biases in Resolving Loan Problems

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.

Keywords: {'name': 'behavioral biases'}, {'name': 'escalation of commitment'}, {'name': 'financial covenant violations'}, {'name': 'covenant waivers'}

Authors & affiliations

Richard Brody
Affiliation not supplied

Matias Sokolowski
Affiliation not supplied

Reilly White
Affiliation not supplied

Deposited references

Supplied references, not a list of publications citing this article.

DOI: 10.1016/j.jfi.2019.03.004

DOI: 10.2139/ssrn.3413860

DOI: 10.1016/j.jacceco.2014.08.009

DOI: 10.3386/w11907

DOI: 10.1017/S0022109019000334

DOI: 10.1093/rof/rfz018

DOI: 10.1016/S0378-4266(98)00038-7

DOI: 10.1111/1468-0297.00682

DOI: 10.5465/amr.1992.4279568

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

DOI: 10.3386/w23879

DOI: 10.1111/j.1475-679X.2011.00432.x

DOI: 10.1111/1475-679X.12108

DOI: 10.1016/j.jacceco.2021.101426

DOI: 10.1111/1911-3846.12544

DOI: 10.1016/j.jacceco.2015.11.001

DOI: 10.2139/ssrn.1559232

DOI: 10.1093/rfs/hhq054

DOI: 10.1111/1475-679X.00083

DOI: 10.1093/rof/rfq008

DOI: 10.1016/j.jbankfin.2012.09.011

DOI: 10.1016/j.jcorpfin.2017.05.009

DOI: 10.1016/j.jfineco.2020.08.017

DOI: 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.

DOI: 10.1016/j.leaqua.2018.03.004

DOI: 10.1037/0021-9010.83.2.206

DOI: 10.1016/j.jfds.2015.07.001

DOI: 10.1093/rcfs/cfy009

DOI: 10.5465/3069358

DOI: 10.1108/RAF-10-2017-0194

DOI: 10.1108/RAF-05-2019-0106

DOI: 10.1016/S0167-4870(99)00002-1

DOI: 10.1016/0148-2963(95)00171-9

DOI: 10.2139/ssrn.1961980

DOI: 10.5465/amr.1981.4285694

DOI: 10.1111/j.1540-6261.2007.01251.x

DOI: 10.1016/S0378-4266(99)00056-4

DOI: 10.1093/rfs/hhu006