The Effects of Underwriting Practices on Loan Losses : Evidence from the FDIC Survey of Bank Lending Practices

Using data from the FDIC survey of bank lending practices from January 1996 to March 2009, we investigate possible determinants of loan underwriting practices and the influence of these practices on loan losses. Specifically, we fit a two-step treatment effects model to consider the effects of underwriting practices on loan losses. In the selection step, we find that for business loans, the selection of low-risk underwriting practices is positively related to strong prior period bank financial condition, management quality, hierarchical complexity, and negatively related to market competition. Results for the selection of lending practices for consumer loans and three categories of real estate loans are similar to those found for business loans but show weaker statistical relationships to all explanatory variables. In the loss determination step we find that lower (higher) risk underwriting practices are generally associated with lower (higher) loan losses for five categories of loans: business, consumer, commercial real estate, home equity, and construction and land development loans. Our results support the commonly held view that credit standards vary cyclically with banking market conditions and demonstrate the important influence lending standards have on loan portfolio performance