Journal of Behavioral Finance

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Using Annual Report Sentiment as a Proxy for

Financial Distress in U.S. Banks

Priyank Gandhi, Tim Loughran & Bill McDonald

To cite this article: Priyank Gandhi, Tim Loughran & Bill McDonald (2019): Using Annual Report
Sentiment as a Proxy for Financial Distress in U.S. Banks, Journal of Behavioral Finance, DOI:
10.1080/15427560.2019.1553176

To link to this article: https://doi.org/10.1080/15427560.2019.1553176

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JOURNAL OF BEHAVIORAL FINANCE
https://doi.org/10.1080/15427560.2019.1553176

Using Annual Report Sentiment as a Proxy for Financial Distress in

U.S. Banks
Priyank Gandhia, Tim Loughranb, and Bill McDonaldb
a
Rutgers Business School; bUniversity of Notre Dame

ABSTRACT KEYWORDS
Current measures of bank distress find marginal value in predictive variables beyond a cap- Financial distress; Textual
ital adequacy ratio and tend to miss extreme events impacting the entire sector. The analysis; Negative
authors advocate a new proxy for bank distress: sentiment measures from banks’ annual sentiment; Distressed
delisting; Financial
reports. After controlling for popular forecasting variables used in the literature, they find institutions
that more negative sentiment in the annual report is associated with larger delisting proba-
bilities, lower odds of paying subsequent dividends, higher subsequent loan loss provisions,
and lower future return on assets. The findings suggest that regulators could augment cur-
rent early warning systems for banks and the banking sector—where the measures are
based exclusively on financial statement data—by using the frequency of negative words in
banks’ annual reports.

Introduction their balance sheet at the end of each quarter or year.

As one of the primary sources of money and credit in
the economy, banks are in a special position to trans-
mit their distress to other sectors. Fluctuations in
bank credit, driven by bank distress, can affect aggre-
gate consumption and investment, and may have sig-
nificant real effects for the macroeconomy. In fact, the
relation between bank distress and business cycles is
at the root of their special regulation and supervision.
For these reasons, it is important to assess which
banks are in financial distress and what effect this
potentially has on their credit supply.
So far, practitioners and regulators have followed
the finance and accounting literature (Altman [1968],
Beaver [1966], Libby [1975], Ohlson [1980]) and used
either financial ratios (e.g., capital adequacy, total
deposits to total assets, and profitability) or CAMELS
(capital adequacy, asset quality, management quality,
earnings, liquidity, and sensitivity to market risk) rat-
ings as early warning systems to evaluate bank distress
and failure. The traditional approaches suffer from 3
limitations.
First, bank managers are keenly aware that certain
financial ratios are scrutinized closely by regulators
and investors, and this gives them the incentive to
undertake temporary transactions to “window dress”
Further, bank managers can use accounting discretion
to provide investors inaccurate financial information
regarding the true value of illiquid assets. In other
words, the traditional predictive model relying on spe-
cific financial ratios suffers from the classic Lucas
[1976] critique: It fails to account for a change in the
behavior of agents.
There is evidence of such behavior during the most
recent financial crisis. For example, Rajan, Seru, and
Vig [2015] showed that in the run-up to the subprime
crisis, banks did not report information regarding
worsening quality of borrowers in statistics reported
to investors and regulators. They argued that this
accounts for poor performance of statistical predictive
models during the subprime crisis. Huizinga and
Laeven [2012] also documented that banks signifi-
cantly overstated the value of their distressed real-
estate assets and regulatory capital. In addition, Allen
and Saunders [1992] provided evidence that banks
engage in window dressing behavior.
Second, identifying distressed banks by comparing
financial ratios to predetermined regulatory thresholds
using historical data, may miss extreme events, when
banks are subject to catastrophic losses, and when
even adequately capitalized banks (based on past
thresholds) may experience distress. During the recent

CONTACT Tim Loughran loughran.9@nd.edu C. R. Smith Professor of Finance, Mendoza College of Business, University of Notre Dame, Notre
Dame, IN 46556-5646.
ß 2019 The Institute of Behavioral Finance
2 P. GANDHI ET AL.
credit crisis, financial institutions such as Washington
Mutual were adequately capitalized and met or
exceeded the regulatory capital rules before they
imploded. The fact that during extreme events regula-
tory capital ratios may no longer be credible is why
the Federal Reserve introduced stress testing as a
new tool.
Finally, most studies of the relation between bank
distress and credit supply rely on one-off exogenous
shocks to identify distressed banks. That is, research-
ers have segmented banks by whether they were (or
were not) impacted by some crisis (e.g., Japanese real
estate, Russian, East Asian crisis). Alternatively,
researchers have identified banks that did (or did not)
receive government funding to measure financial dis-
tress of banks. Such methods do not allow us to meas-
ure financial distress of banks outside crisis episodes.
Our article attempts to take a very different
approach to measuring the financial distress of U.S.
banks. We use the sentiment of annual reports (i.e.,
Form 10-K) to gauge the likelihood of distress. Our
intuition is that the sentiment of words used by man-
agers to describe their firm’s economic situation
should signal when a bank is financially distressed.
Prior articles find that linguistic cues in annual
reports can help detect financial fraud (Purda and
Skillicorn [2015]) and financial constraints (Law and
Mills [2015]).
We consider the negative sentiment category pro-
posed by Loughran and McDonald [2011]. Their list
was created by examining words occurring in Form
10-Ks to consider their most likely usage in financial
documents. The Loughran and McDonald [2011]
negative word list has been widely used in both the
accounting and finance literature to measure senti-
ment in financial documents, newspaper articles, ana-
lyst reports, and even earnings conference call
transcripts (see Das [2014], Kearney and Liu [2014],
Loughran and McDonald [2016]).
The current version of their word list contains
2,355 negative words. The most commonly appearing
Loughran and McDonald [2011] negative words in
annual reports are loss, losses, claims, impairment,
against, adverse, and restated. We focus only on nega-
tive words to measure document sentiment because
earlier articles by Tetlock [2007] and Loughran and
McDonald [2011] found limited incremental value for
other categories like positive words.
We argue that accounting measures are problematic
because they can be influenced by managers—doesn’t
the same logic apply to sentiment in annual reports?
We believe that litigation risk plays a role in
constraining managers from being overly optimistic in
their annual report word usage. Rogers, Van Buskirk,
and Zechman [2011] found that optimistic (i.e., less
pessimistic) language in financial disclosures substan-
tially increases litigation risk. A 1-SD increase in their
aggregate optimism factor is linked with a 75.9%
increase in the probability that the firm will be sued.
Kim and Skinner [2012] reported that the vast major-
ity of securities class action lawsuits allege a violation
of SEC Rule 10b-5 (a misstatement or omission of
material information). In addition, Skinner [1994]
highlighted the reputational costs to managers when
they fail to disclose negative news to shareholders in a
timely manner. Thus, firm managers have a strong
incentive to avoid spurious or specious language in
Form 10-K filings.
To gauge financial distress, we examine 4 separate
variables in the year following the annual report filing:
distressed delisting from the NYSE, Amex, or Nasdaq
exchanges; dividend payments; percent loan loss pro-
visions; and return on assets (ROA). We find that
banks with a higher fraction of negative words in their
annual report: have a higher probability of a subse-
quent distressed delisting, are less likely to pay divi-
dends in the future, have a higher subsequent fraction
of loans being potentially delinquent, and have lower
subsequent ROA. This relation holds with or without
control variables like market capitalization, capital
adequacy ratio, excess prior returns, and gross file size
of the 10-K. Banks facing delisting from an exchange,
not paying dividends to shareholders, having high
loan loss provisions as a fraction of total loans, or low
profitability will likely not be robust participants in
the local economy.
As an example, consider Hamilton Bancorp’s (CIK
¼ 894172) 10-K filing on April 14, 2000. In their
annual report, 1.94% of Hamilton Bancorp’s words
were negative relative to the total number of words in
the firm’s Form 10-K. This was one of the highest fre-
quencies in calendar year 2000 of any bank (the mean
for that year was 1.29%), and higher than any other
10-K filed by Hamilton Bancorp. At the time of the
10-K filing, the bank had a stock price of $17.375
(above its 1997 IPO price of $15.50) and a market
value of $175 million. Yet, the bank’s high frequency
count of negative words should have warned regula-
tors and investors of impending difficulties. Hamilton
Bancorp, in the following year, suffered a low ROA
value, did not issue dividends, and experienced a very
high percentage of loan loss provisions. The bank had
a distressed delisting from Nasdaq on January 11,
2002, with a last price of only $1.65.

Our findings are important for at least 2 reasons.
First, they suggest that regulators and supervisors could
tabulate the frequency of negative words in annual
reports of all banks to monitor the collective health of
financial intermediaries and to identify distress in the
banking sector. The relative frequency of negative
words could be viewed as a supplement to existing var-
iables in measuring financial distress. For example, an
increase in the frequency of negative words in annual
reports of all (vs. a few) banks may signal a systemic
problem and may help identify periods when regulators
should or should not intervene in financial markets.
Second, regulators, auditors, and supervisors can
incorporate the results of our study in models of early
warning systems that can, on a case-by-case basis,
help identify banks that are beginning to experience
problems. Friend and Levonian [2013] showed that
information from financial markets (e.g., the negative
sentiment from the annual report measure in this art-
icle) can be a valuable supplement to nonpublic infor-
mation acquired by regulators in identifying problem
banks. Any technique that even marginally improves
the ability of regulators to assess the conditions of
banks is beneficial as it enables supervisors to inter-
vene in a timely manner and may help avoid outright
bank failure or costly bailouts once a bank is in dan-
ger of imminent failure.
Our article is also related to the large literature in
corporate finance that attempts to measure the sever-
ity of financial constraints for firms. While many
measures of financial constraints have been suggested
(see Fazzari, Hubbard, and Petersen [1988], Lamont,
Polk, and Saa-Requejo [2001], Whited and Wu
[2006]), our approach is most similar to that advo-
cated by Kaplan and Zingales [1997] and Hadlock and
Pierce [2010]. These articles use qualitative informa-
tion in statements made by managers in SEC filings
to measure a firm’s financial constraints. However,
both Kaplan and Zingales and Hadlock and Pierce
make it a point to exclude all financial firms (i.e.,
firms with SIC codes from 6000 to 6999).
A number of the existing risk-based measures of
banks rely on market prices of bank stocks and bonds.
However, in the presence of implicit or explicit gov-
ernment guarantees, these risk measures may be unin-
formative about future risk. As shown by Atkeson,
Eisfeldt, and Weill [2017], there was no difference in
the financial soundness between large U.S. financial
and large nonfinancial firms in the run-up to the
most recent financial crisis. Thus, market-based meas-
ures and lagged equity returns may be a noisy way to
forecast bank stress. Bond and Goldstein [2015]
JOURNAL OF BEHAVIORAL FINANCE 3
argued that market prices (especially for financial
intermediaries) reflect the regulator and government
policies in place. In the recent financial crisis, it was
apparent that the prospect of government help was
repeatedly a major driver of changes in asset prices,
both in the United States and in many other econo-
mies. Our measure of using sentiment of the annual
report as a proxy for bank financial distress is a for-
ward-looking measure that works.
Literature review
Historically, for bank failures or bankruptcies, the lit-
erature has found bank capital to be a key variable.
Lower levels of capital are associated with higher
probabilities of a bank’s failure (see Cole and Gunther
[1995], Estrella, Park, and Peristiani [2000]).
Obviously, as bank managers know that regulators are
focusing on a few key ratios, the incentive to manage
the reported number is substantive.
In an important article, Huizinga and Laeven
[2012] found that U.S. financial institutions overstated
the value of their real-estate assets and regulatory cap-
ital during the most recent financial crisis. Their find-
ing helps explain why regulators failed to identify
banks that were destined to fail. The United States is
not the only country to suffer from poor bank over-
sight; European regulators also failed to address ser-
ious bank issues until it was too late.
Several articles have emphasized the role of market
discipline in monitoring banks. For example, Flannery
and Sorescu [1996] found that investors react to
changing regulatory environments in the pricing of
bank subordinated notes and debentures. Once gov-
ernment regulators stopped protecting bank holding
companies’ creditors, investors quickly became more
diligent in pricing bank default risk. Although he
excluded financial institutions from his analysis,
Shumway [2001] highlighted the importance of using
market-determined independent variables to forecast
bankruptcy. Along those lines, in this article we found
that market capitalization (stock price multiplied by
shares outstanding) and prior stock return perform-
ance are consistently powerful and significant explana-
tory variables for bank distress.
As an example motivating our use of market-deter-
mined independent variables, see Wells Fargo’s 10-K
filing on February 27, 2009. At that time, Wells Fargo
had more than $1.2 trillion in total assets, positive
trailing earnings of more than $2.5 billion, and had
capital well above the regulatory minimum amount
for a well-capitalized financial institution. Yet, the
4 P. GANDHI ET AL.
bank had lost more than half of its market capitaliza-
tion in the prior year which accurately reflected the
immense turmoil faced by the firm. Consistent with
distress, at the time, the bank’s 10-K filing reported
its highest frequency of negative words (more than
1.92%, vs. the firm’s average of 1.45%).
In the bankruptcy literature for nonfinancial firms,
the Altman [1968] z-score is commonly used as a
proxy for firm distress. However, a number of the
financial ratios in the Altman z-score are completely
irrelevant for financial institutions. That is, working
capital/total assets and sales/total assets, 2 of the 5
components of the Altman z-score, are not applicable
for gauging bank distress. Instead, the banking litera-
ture typically will use a z-score based on the bank’s
(ROA þ capital asset ratio)/standard deviation of the
ROA (see Laeven and Levine [2009], Demirg€ uç-Kunt
and Huizinga [2010]). However, such a z-score suffers
from a clear look-ahead bias because the standard
deviation of ROA is measured over the entire sample
period. In contrast to the z-score, our independent
control variables will be known to all regulators and
investors at the time of the annual report filing.
One contemporaneous article also uses annual
report text to measure financial institution instability.
Hanley and Hoberg [2017], in an approach different
from ours, examine the pairwise return comovement
between 2 banks and 18 semantic risk themes. Their
10-K risk themes include credit default, mortgage risk,
fair value, and taxes. The basic idea is that 2 banks
jointly exposed to a particular risk factor should move
together. If systemic risk is growing in the banking
industry, a regression of pairwise covariance on the 18
semantic risk themes will be highly significant. In
their Figure 1, the aggregate systemic risk measure is
shown to peak in early 2006, before the financial
meltdown of 2008. However, their aggregate systemic
risk measure is quite low following the 9/11 terrorist
attacks and in the middle of 2009 when the economy
was hitting rock bottom. In contrast, our frequency of
negative words shows a rise in 2002 and a spike in
early 2009 following the financial meltdown.
Sample selection, 10-K parsing, variable
definitions, and descriptive statistics
Sample selection
Our sample is created by combining 3 different data
sources: the Federal Reserve Bank of Chicago’s con-
solidated financial statements for bank holding com-
panies (FRY-9C) provides detailed information on
commercial banks’ income statements and balance
sheets; the SEC’s Electronic Data Gathering, Analysis,
and Retrieval (EDGAR) database provides the bank’s
annual reports; and the Center for Research in
Security Prices (CRSP) is used for stock market infor-
mation. From the FRY-9C data, we obtain the follow-
ing variables: provision for loan losses, net income,
total loans, total assets, deposits, Tier 1 capital, Tier 2
capital, and dividends for the universe of commercial
banks. The Federal Reserve Bank of New York’s
CRSP-Federal Reserve Bank link is used to match the
Central Index Key (CIK) with the bank’s CRSP
permco (see https://www.newyorkfed.org/research/
banking_research/datasets.html). The CIKs are used
to search the EDGAR database for the annual reports
(i.e., Form 10-K). Our sample includes large, systemically
important banks like Bank of America, Wells Fargo,
Citigroup, Wachovia Corporation, and Chase Manhattan.
The bank market capitalizations, delisting codes,
and stock returns are obtained from CRSP. Although
some articles do not require banks in the sample to
be publicly-traded, including market capitalization
and prior stock performance seems like the most
obvious control variables for an analysis of financial
distress. As noted by Flannery [1998], “The fact that
market data are not available for many banks does
not justify ignoring this information for the largest
banking firms, which pose the greatest challenge to
federal regulators’ supervisory abilities” (p. 281).
Table 1 reports the impact of various data screens
on the combined FRY-9C, EDGAR, and CRSP data-
bases. The initial sample of bank-year observations is
7,279. Following the Loughran and McDonald [2011]
methodology, 1 observation is dropped because the
10-K contains an insufficient number of words (i.e.,
less than 2,000). A total of 282 observations are
dropped due to missing CRSP market values. The
Fama and French [1997] Industry code of 44
(“Banks”) requirement drops 185 firms from the sam-
ple. This screen eliminates nonbanks such as MetLife,
Goldman Sachs, Morgan Stanley, Charles Schwab, and
American International Group from the sample even
though such firms are in all 3 of the FRY-9C,
EDGAR, and CRSP databases. Missing FRY-9C infor-
mation drops several hundred observations. Our final
sample consists of 6,223 bank-year observations.
10-K parsing
As in Loughran and McDonald [2011], we start by
removing all HTML and ASCII-encoded segments
from each bank annual report text file obtained from
EDGAR. Collections of text identified in HTML as
 JOURNAL OF BEHAVIORAL FINANCE 5

2
% Negative Words in 10-K
1.4 1.6
1.2 1.8

1997 2000 2003 2006 2009 2012 2014

Year

Figure 1. Time-series trend in % Negative for the sample of U.S. banks, 1997–2014.
% Negative is the number of Loughran-McDonald [2011] negative words in the 10-K divided by the total number of words in the
10-K.

Table 1. Sample creation.

Dropped Sample Size
FRY-9C and SEC 10-K combined data 1997–2014 7,279
Drop if number of 10-K words is < 2,000 1 7,278
Drop if total loans equals $0 5 7,273
Drop if missing market capitalization at 10-K filing date 282 6,991
Fama-French Industry must be Banks 185 6,806
Drop if deposits or deposit interest expense equals $0 6 6,800
Drop if CRSP returns in prior year are missing 14 6,786
Drop if missing FRY-9C dividend data 435 6,351
Drop if missing FRY-9C Tier 1 and Tier 2 capital data 128 6,223
Note. The table reports the impact of various data filters on the combined FRY-9C commer-
cial bank, SEC EDGAR 10-K, and CRSP databases. The sample consists of bank common
stocks listed on NYSE, Amex, and Nasdaq with available FRY-9C, EDGAR 10-K, and CRSP
data from January 1997 to December 2014.

tables are removed if their numeric character content
is greater than 10%. The annual report text is then
parsed into a vector of words that are tabulated using
the Loughran and McDonald master dictionary. Note
that the Loughran and McDonald master dictionary
does not include abbreviations, acronyms, single letter
words, or proper nouns.
% Negative time series patterns
As noted previously, in this article, we focus only on
the Loughran-McDonald [2011] negative word list to
measure the sentiment of bank annual reports. Figure
1 plots the average relative frequency of negative
words relative to the total number of words in the
Form 10-K during the sample period. For the overall
sample of 6,223 bank-year observations, the average
value for % Negative is 1.56%. Over our time period,
1997–2014, the tone of bank annual reports has
become increasingly negative. For example, the aver-
age 10-K in 1997 contains 1.26% negative words com-
pared with 2.03% by 2014.
The frequency of negative words is flat in the first 5
years of the sample. However, following the 9/11 ter-
rorist attacks and the economic slowdown, the senti-
ment of annual reports steadily becomes more
negative. The average negative sentiment in bank 10-Ks
quickly accelerates following the financial melt-down in
fourth quarter of 2008. Since the bulk of banks have a
fiscal year end of December 31, the vast majority file
their 10-K in March and April. Thus, the impact of the
fourth quarter of 2008 will not be reflected in annual
report sentiment until calendar year 2009.
For the last 4 years of the sample, the trend in %
Negative is flat, although at a historically high level
(more than 2%). As reported in Murphy, Purda, and
Skillicorn [2018], top managers play an important role
in writing sections of the annual report pertaining to
forward-looking information. Clearly, the sentiment of
the annual report reflects concern by management of
greater problems as time progresses. The 2007–2014
time period was an extremely stressful period for U.S.
banks, and the sentiment of the annual report cer-
tainly mirrors this.
6 P. GANDHI ET AL.
Variable definitions
Our 4 dependent variables of interest are Distressed
Delisting Dummy, Dividend Dummy, % Loan Losses,
and ROA. The Distressed Delisting Dummy equals 1 if
the bank has a distressed CRSP delisting code (i.e.,
CRSP dlstcd variable in the range of 300–599) within 3
subsequent years of the 10-K filing date, else 0. The
Dividend Dummy equals 1 if the bank pays dividends
to shareholders in the subsequent year, else 0. The %
Loan Losses is subsequent provisions for loan losses
scaled by total loans. ROA is defined as subsequent net
income scaled by total assets. Both the % Loan Losses
and ROA variables are winsorized at the 1% level.
The bank-specific control variables are: (a) Capital
Adequacy, the ratio of (Tier 1 capital and Tier 2 cap-
ital)/total assets at the time of the 10-K filing; (b)
Log(Mkt Cap), the log of market capitalization (stock
price multiplied by shares outstanding) in thousands
of dollars 2 days before the 10-K filing date; (c)
Log(Gross File Size), the size of the SEC EDGAR
“complete submission text file” for the 10-K filing;
and (d) Excess Prior Returns, the buy-and-hold bank
stock returns minus the buy-and-hold returns of the
CRSP value-weighted index over an identical period
in the year before the 10-K filing date. Loughran and
McDonald [2014] recommend using the gross file size
of the 10-K as an easily obtained proxy for document
complexity/readability. For Dividend Dummy, % Loan
Losses, and ROA, we also include the lagged values of
the variables in the regressions. More detailed variable
descriptions are provided in Appendix A.
Matching of annual reports with subsequent FRY-
9C quarterly data
Bodnaruk, Loughran, and McDonald [2015] men-
tioned a potential linkage between annual report tone
and accounting-based information due to an overlap
in time. To illustrate the issue, it is best to use an
example. Wells Fargo & Company (CIK ¼ 72971)
filed its fiscal year 2003 10-K on March 12, 2004. The
bank’s annual report for the following fiscal year
(2004) was filed on EDGAR on March 10, 2005. Thus,
71 days of fiscal year 2004 had passed before Wells
Fargo filed their 2003 fiscal year annual report on
March 12, 2005. It is conceivable that bank managers
became aware of changes in their loan quality, profit-
ability, or economic market conditions during the
early part of calendar year 2004, and that this new
information affected their word selection for the 10-K.
Hence, it is possible that any relation between 10-K
pessimistic sentiment and accounting-based variables
might be due, in part, to this overlap in time.
To completely avoid this issue, our methodology
matches the annual report sentiment with the subse-
quent year’s first quarter FRY-9C data. That is, the
negative word count of Wells Fargo’s 2003 fiscal year
annual report, filed on March 12, 2004, forecasts the
bank’s March 31, 2005, FRY-9C accounting informa-
tion, filed on May 5, 2005. This completely eliminates
any possible time overlap between sentiment and sub-
sequent accounting variables.
Summary statistics and correlations
Table 2 reports the summary statistics (Panel A) and
the correlations between the key variables of interest
in our article (Panel B). The mean value of % Negative
(1.56%), although low, is consistent with prior articles,
and, consistent with the general distribution of words
for a word list of this length. For example, Loughran
and McDonald [2011] reported a mean value for %
Negative of 1.39% for their sample of 10-Ks during the
1994–2008 time period. For a sample of newspaper
articles during 2002 to 2006, Gurun and Butler [2012]
reported a mean value for % Negative of 1.69%.
At the 95th percentile, % Negative is 2.22% compared
with a value of 0.98% for the fifth percentile. Slightly
more than 2% of our bank sample have a distressed
delisting within 3 years while more than 85% of the sam-
ple issue dividends next year. The average % Loan Losses
and ROA in year t are 0.63% and 0.81%, respectively.
In Panel B of Table 2, the correlations between key
variables are summarized. The fraction of negative
words in the 10-K generally relate to the other varia-
bles of interest in an expected manner. The correl-
ation between % Negative and log(Mkt Cap) is only
slightly positive (0.046), thus, importantly, negative
sentiment does not merely proxy for bank size.
The relation between % Negative and log(Gross file
size) is strong (0.657). Both Li [2008] and Bloomfield
[2008] mentioned that firms with problems (like
losses) may require more explanation and greater
detail in their annual report compared with firms
which had a strong performance. Gross file size prox-
ies for the number of words, tables, exhibits, HTML
code, and graphics contained in the Form 10-K. As
the annual report becomes lengthier and more com-
plex, investors have more difficulty incorporating the
document’s information into stock prices and earnings
forecasts (see You and Zhang [2009], Lehavy, Li, and
Merkley [2011], Loughran and McDonald [2014]).
 JOURNAL OF BEHAVIORAL FINANCE 7

Table 2. Summary statistics and variable correlations.

Panel A: Summary statistics
Variable Mean Median Standard Deviation 5% 95%
% Negativei,t 1.56% 1.52% 0.38% 0.98% 2.22%
Distressed Delisting Dummyi,tþ1 2.12% 0.00% 14.41% 0.00% 0.00%
Dividend Dummyi,tþ1 85.96% 100.00% 34.75% 0.00% 100.00%
% Loan Lossesi,t 0.63% 0.35% 0.85% 0.06% 2.35%
ROAi,t 0.81% 0.95% 0.80% –0.44% 1.67%

Panel B: Correlations
Capital Log Log(Gross Excess Delisting Dividend % Loan
% Negative Adequacy (Mkt Cap) File Size) Prior Returns Dummy Dummy Losses
Capital Adequacyi,t 0.147
Log(Mkt Cap)i,t 0.046 0.031
Log(Gross File Size)i,t 0.657 0.162 0.280
Excess Prior Returnsi,t –0.120 –0.018 0.086 –0.083
Distressed Delisting Dummyi,tþ1 0.085 –0.026 –0.109 0.044 –0.120
Dividend Dummyi,tþ1 –0.068 –0.042 0.227 0.021 0.073 –0.166
% Loan Lossesi,tþ1 0.171 0.035 0.024 0.115 –0.179 0.254 –0.111
ROAi,tþ1 –0.244 0.074 0.177 –0.202 0.267 –0.296 0.232 –0.509
Note. The table reports the summary statistics and correlations for the key variables in our bank sample. The % Negative variable is the number of
Loughran-McDonald [2011] negative words in the 10-K divided by the total number of words in the 10-K. Capital Adequacy is (Tier 1 capital þ Tier 2
capital)/total assets. Market Cap is stock price multiplied by shares outstanding (in thousands of dollars) as of 2 days before the 10-K filing date. Gross
File Size is the file size in megabytes of the SEC EDGAR “complete submission text file” for the 10-K filing. Excess Prior Returns is the buy-and-hold firm
returns minus the buy-and-hold returns of the CRSP value-weighted index over an identical period in the year before the 10-K filing date. Distressed
Delisting Dummy equals 1 if the bank has a distressed CRSP delisting within 3 subsequent years of the 10-K filing date, else 0. Dividend Dummy equals
1 if the bank issues dividends in the subsequent year, else 0. % Loan Losses is defined as the ratio of provisions for loan losses in the subsequent year
scaled by total loans in the subsequent year. ROA is defined as subsequent year net income divided by subsequent year total assets.

As expected, more negative annual report sentiment is
correlated with lower prior excess stock returns, not issu-
ing subsequent dividends, and lower subsequent ROA
values. Conversely, % Negative is positively correlated
with Distressed Delisting Dummy (0.085) and subsequent
loan loss fractions (0.171). The Distressed Delisting
Dummy is strongly correlated with both % Loan Losses
(0.254) and ROA (–0.296). Note that Excess Prior Returns
and ROA are positively correlated with each other
(0.267). That is, better performing stocks have higher sub-
sequent profitability. Somewhat surprisingly, % Negative
and Capital Adequacy are positively correlated (0.147).
Empirical findings
Distressed Delisting Dummy
Regulators devote tremendous resources attempting to
identify banks that are likely to fail. Certainly, having
a distressed delisting from a major U.S. stock
exchange would be categorized as a failure for all par-
ties involved. Could word selections by managers
assist investors and regulators in highlighting which
financial institutions, controlling for bank size, capital
adequacy, and past performance, are more likely to
be delisted?
In Table 3, we estimate the logit regressions of
Distressed Delisting Dummy:
Distressed Delisting Dummyi;tþ1 ¼ a þ b1 % Negativei;t
þ b2 Capital Adequacyi;t þ b3 Log ðMkt CapÞi;t
þ b4 Log ðGross File SizeÞi;t þ b5 Excess Prior Returnsi;t þ ei;t
(1)
where % Negativei,t is the count of words from the
Loughran and McDonald [2011] negative word list
divided by the total number of words in the Form 10-
K (expressed as a percent). The dependent variable,
Distressed Delisting Dummyi,tþ1, equals 1 if the bank
has a distressed CRSP delisting within 3 subsequent
years of the 10-K filing date, else 0. As noted by the
subscripts, our independent variables are all known at
the time of the 10-K filing date. Thus, the right hand
side variables are predicting a future delisting event.
In all of our regressions, calendar-year dummies
and a constant are always included. Robust z-statistics,
in parentheses, are reported below the coeffi-
cient estimates.
As a first step, it is important to show that the rela-
tion of % Negative with the Distressed Delisting
Dummy is significant without the presence of the
firm-specific control variables. In the first regression,
% Negative is the only independent variable besides
the calendar-year dummies and a constant. In column
2, the coefficient on % Negative is positive (1.923) and
statistically significant at the 1% level (z-statistic of
6.10). More negative language in the annual report is
associated with a higher probability of subsequently
having a distressed delisting.
In column 2, our 4 firm-level control variables are
added to the regression. Three of the 4 control
8 P. GANDHI ET AL.

Table 3. Logit regressions of distressed delisting dummy on In column 3, when we restrict the sample to only
% Negative from the Loughran-McDonald [2011] word lists banks with total assets of less than $1 billion, similar
and firm characteristics.
to Berger and Bouwman [2013], we find that the cap-
< $1 Billion in
All Banks Total Assets ital adequacy ratio coefficient is negative (–21.102)
and statistically significant (z-statistic of –2.22) in
1 2 3 4
% Negative 1.923 1.679 1.699
explaining subsequent delisting when it is the only
(6.10) (5.10) (3.86) control variable beyond calendar-year dummies. Thus,
Capital Adequacy 1.100 –21.102 –4.548
(0.19) (–2.22) (–0.50)
higher capital for small banks implies a lower prob-
Log(Mkt Cap) –0.844 –1.140 ably of delisting within the next 3 years.
(–7.73) (–4.38) However, once % Negative, log(Mkt Cap), and the
Log(Gross File Size) 0.386 0.418
(2.69) (2.14) other control variables are included as explanatory
Excess Prior Returns –1.514 –0.884 variables in column 4, the statistical significance of
(–2.91) (–1.49)
Sample size 5,966 5,966 2,244 2,244 the Capital Adequacy variable completely disappears
Pseudo R2 14.64% 26.09% 14.34% 22.80% for a sample composed of small banks. As noted ear-
Note. The table presents the results of logit regressions of Distressed lier by Shumway [2001], market-driven variables often
Delisting Dummy on the Loughran-McDonald [2011] word lists and firm
characteristics. The Distressed Delisting Dummy equals 1 if the bank has significantly outperform accounting-based ratios in
a distressed CRSP delisting within 3 subsequent years of the 10-K filing predicting financial distress or even bankruptcy. In
date, else 0. The % Negative variable is the number of Loughran-
McDonald [2011] negative words in the 10-K divided by the total num- contrast to Capital Adequacy, % Negative remains sig-
ber of words in the 10-K. The other variable definitions are available in nificant at the 1% level in the presence of market-
Appendix A. In columns 3 and 4, the sample is restricted to banks with
total assets of less than $1 billion as of the 10-K filing date. The sample driven variables. When the sample is restricted to
consists of bank common stocks listed on NYSE, Amex, and Nasdaq small banks, the coefficient on % Negative differs only
with available FRY-9C, EDGAR 10-K, and CRSP data from January 1997
to December 2014. Robust z-statistics, in parentheses, are reported slightly compared with its value for the all banks sam-
below the coefficient estimates. Calendar-year dummies and a constant ple (1.699 vs. 1.679).
are included in all regressions but are not tabulated.
It is important to provide some sense of the eco-
nomic significance of the % Negative coefficient value
in Table 3. The marginal effect of the % Negative
variables are statistically significant. The control vari-
coefficient is 0.032 while the standard deviation of %
able coefficients imply that smaller, poorly performing
Negative is 0.381. Thus, a 1-SD increase in percentage
banks with larger gross 10-K file sizes are more likely
of negative words is associated with a 58.06%
to subsequently have a distressed delisting. Notice that
the coefficient on the Capital Adequacy variable has a (¼0.0320.381/distressed delisting dummy mean of
positive sign; however, it is not statistically significant. 0.021) higher chance of a distressed delisting.
This lack of significance for the key regulatory ratio
highlights the inability of a simple financial ratio to fore- Dividend Dummy
cast subsequent bank distress. As bank managers consist-
If a financial institution elects not to issue dividends
ently ensure the Capital Adequacy ratio is at acceptable
levels, the variable has very limited predictive ability. to its shareholders, it is likely that the bank feels some
Why do other articles find that the capital concern about future operations and liquidity needs.
adequacy ratio has predictive power in explaining Over 85% of our bank sample issues dividends in the
bank failures or bank delistings? For example, Berger subsequent year. Floyd, Li, and Skinner [2015] docu-
and Bouwman [2013] report that higher capital ratios mented that even as the 2007–2008 financial crisis
assist small banks (i.e., less than $1 billion in total began, banks were reluctant to cut dividends. Thus, it
assets) in surviving. In contrast, they find that higher is fairly common for banks to pay out excess profits
capital helps medium and large sized banks to survive to shareholders in the form of dividends during our
only during banking crises. Similarly, Jagtiani et al. time period. Banks without excess profits or cash
[2003] found, in a sample of banks with total assets flows probably are also limiting access to credit of the
between $300 million and $1 billion, that the capital communities they serve. In Table 4, we estimate the
adequacy ratio is consistently statistically significant logit regressions of Dividend Dummy:
each quarter in predicting bank failures. However, Distressed Delisting Dummyi;tþ1 ¼ a þ b1 % Negativei;t
none of these articles include market capitalization as þ b2 Lagged Dividend Dummyi;t þ b3 Capital Adequacyi;t
a control variable because their samples include banks þ b4 LogðMkt CapÞi;t þ b5 LogðGross File SizeÞi;t
regardless of whether or not the firm is listed on þ b6 Excess Prior Returnsi;t þ ei;t
an exchange. (2)

Table 4. Logit regressions of dividend dummy on % Negative
from the Loughran-McDonald [2011] word lists and firm
characteristics.
1 2
% Negative –0.802 –0.395
(–5.58) (–2.14)
Lagged Dividend Dummy 3.651
(29.35)
Capital Adequacy –3.196
(–1.35)
Log(Mkt Cap) 0.392
(10.17)
Log(Gross File Size) 0.120
(1.45)
Excess Prior Returns 0.746
(3.78)
Sample size 6,223 6,223
Pseudo R2 1.70% 34.39%
Note. The table presents the results of logit regressions of Dividend
Dummy on % Negative from the Loughran-McDonald [2011] word lists
and firm characteristics. The Dividend Dummy equals 1 if the bank issues
dividends in the subsequent year, else 0. The % Negative variable is the
number of Loughran-McDonald [2011] negative words in the 10-K div-
ided by the total number of words in the 10-K. The other variable defi-
nitions are available in Appendix A. The sample consists of bank
common stocks listed on NYSE, Amex, and Nasdaq with available FRY-
9C, EDGAR 10-K, and CRSP data from January 1997 to December 2014.
Robust z-statistics, in parentheses, are reported below the coefficient
estimates. Calendar-year dummies and a constant are included in all
regressions but are not tabulated.
where % Negative is defined as before, and the
dependent variable, Dividend Dummyi,tþ1, equals 1 if
the bank issues dividends to shareholders in the sub-
sequent year, else 0.
As would be expected, in column 1, the coefficient
on % Negative is negative (–0.802) with a z-statistic of
–5.58. Thus, more pessimistic sentiment in the annual
report foreshadows a lower probability of subse-
quently issuing dividends to shareholders. The control
variables, in column 2, indicate that banks that issued
dividends last year, are larger in size, and have had
higher prior stock returns, are more likely to issue
dividends in the future. Even in the presence of the
control variables, the coefficient on % Negative
remains significant.
The marginal effect of the % Negative coefficient is
–0.029 while the standard deviation of percentage of
negative words is 0.381. Thus, a 1-SD increase in per-
centage of negative words is associated with a 1.28%
(¼–0.029  0.381/dividend dummy mean of 0.860)
lower chance of issuing dividends next year.
% Loan Losses
How well does the sentiment of the annual report
predict subsequent loan problems for the bank? One
might assume that more negative sentiment in Form
10-K should be associated with higher future loan loss
provisions for the financial institution. In Table 5, we
JOURNAL OF BEHAVIORAL FINANCE 9
Table 5. Regressions of % Loan Losses on % Negative from
the Loughran-McDonald [2011] word lists and firm
characteristics.
1 2
% Negative 0.092 0.040
(8.08) (3.81)
Lagged % Loan Losses 0.096
(13.37)
Capital Adequacy 0.234
(1.73)
Log(Mkt Cap) 0.005
(3.07)
Log(Gross File Size) 0.010
(2.22)
Excess Prior Returns –0.060
(–5.54)
Sample size 5,455 5,455
R2 26.66% 35.66%
Note. The table presents the results of regressions of % Loan Losses on %
Negative from the Loughran-McDonald [2011] word lists and firm char-
acteristics. The dependent variable, % Loan Losses, is defined as the
ratio of provisions for loan losses in the subsequent year scaled by total
loans in the subsequent year. The % Negative variable is the number of
Loughran-McDonald [2011] negative words in the 10-K divided by the
total number of words in the 10-K. The other variable definitions are
available in Appendix A. The sample consists of bank common stocks
listed on NYSE, Amex, and Nasdaq with available FRY-9C, EDGAR 10-K,
and CRSP data from January 1997 to December 2014. Robust t-statistics,
in parentheses, are reported below the coefficient estimates. Calendar-
year dummies and a constant are included in all regressions but are
not tabulated.
estimate the regressions of % Loan Losses:
% Loan Lossesi;tþ1 ¼ a þ b1 % Negativei;t
þ b2 % Loan Lossesi;t þ b3 Capital Adequacyi;t
þb4 Log ðMkt CapÞi;t þ b5 Log ðGross File SizeÞi;t
þb6 Excess Prior Returnsi;t þ ei;t
(3)
where % Negative is defined as before and the
dependent variable, % Loan Lossesi,tþ1, is the ratio of
provision of loan losses in the subsequent year scaled
by total loans in the subsequent year.
The first regression of Table 5 reports that %
Negative has a positive and significant coefficient
value when calendar-year dummies are the only other
independent variables. When the 5 control variables
are added to the column 2 regression, the coefficient
value on % Negative drops from 0.092 to 0.040, yet
remains significant at the 1% level (t-statistic of 3.81).
More negative sentiment in the annual report is
linked with higher subsequent loan loss provisions for
the bank. The control variables suggest that banks
with higher prior loan loss provisions, larger market
capitalizations, bigger 10-K file size, and worse prior
stock return performance have higher future loan loss
provisions. Notice that the coefficient value of Lagged
% Loan Losses is significantly less than 1 (0.096). This
is because the dependent variable is the first quarter
provision of loan loss scaled by total loans while the
10 P. GANDHI ET AL.
independent variable is the annual provision of loan
losses scaled by total loans.
The finding of larger banks having higher loan loss
provisions is consistent with the evidence of Boyd and
Gertler [1993] and Gorton and Rosen [1995]. As
noted by Boyd and Gertler [1993], “Increased risk tak-
ing by large banks leads to large banks’ extra-normal
loan loss performance” (p 323). Gorton and Rosen
[1995] found that large banks often have managerial
entrenchment problems; they asserted that “for large
U.S. banks, corporate control problems have been the
cause of the conditions of which moral hazard may be
an accurate characterization” (p. 1410).
For the economic significance of negative words, a
1 standard deviation increase in percentage of nega-
tive words is associated with a 9.3% (¼0.040  0.381/
% loan loss provisions mean of 0.163 in first quarter
of year t þ 1) higher subsequent percentage loan
loss provisions.
ROA
Our last dependent variable is ROAi,tþ1, defined as net
income scaled by total assets in the subsequent year.
Can annual report sentiment be significantly linked
with future bank profitability? Higher profitability will
enable the bank to make more loans and take a more
active role in their communities. In Table 6, we esti-
mate the regressions of ROA:
ROAi;tþ1 ¼ a þ b1 % Negativei;t þ b2 % ROAi;t
þ b3 Capital Adequacyi;t þ b4 Log ðMkt CapÞi;t
þ b5 Log ðGross File SizeÞi;t þ b6 Excess Prior Returnsi;t þ ei;t
(4)
where % Negative is defined as before. Notice that
lagged ROA is included as one of our con-
trol variables.
The first regression of Table 6 shows that %
Negative has a significant relation with future ROA
without the presence of the firm-specific control vari-
ables. The coefficient on % Negative suggests that
more pessimistic 10-K sentiment is negatively linked
to subsequent profitability. More words in the annual
report like loss, losses, adverse, burdens, disastrous, and
exposed, indicate lower future ROA.
The second regression notes that % Negative is sig-
nificant at the 5% level (t-statistic of –2.12) when the
firm-specific control variables are included. As in the
other regressions, the control variables have strong
linkages with the dependent variable. As expected,
higher lagged ROA is positively linked with subse-
quent ROA. Larger banks and financial institutions
with stronger prior performance and a larger capital
Table 6. Regressions of ROA on % Negative from the
Loughran-McDonald [2011] word lists and firm characteristics.
1 2
% Negative –0.064 –0.020
(–5.92) (–2.12)
Lagged ROA 0.087
(15.82)
Capital Adequacy 0.766
(4.85)
Log(Mkt Cap) 0.012
(7.89)
Log(Gross File Size) –0.008
(–1.94)
Excess Prior Returns 0.057
(5.46)
Sample size 6,223 6,223
R2 20.71% 33.08%
Note. The table presents the results of regressions of ROA on % Negative
from the Loughran-McDonald [2011] word lists and firm characteristics.
The dependent variable, ROA, is defined as subsequent year net income
divided by subsequent year total assets. The % Negative variable is the
number of Loughran-McDonald [2011] negative words in the 10-K div-
ided by the total number of words in the 10-K. The other variable defi-
nitions are available in Appendix A. The sample consists of bank
common stocks listed on NYSE, Amex, and Nasdaq with vailable FRY-9C,
EDGAR 10-K, and CRSP data from January 1997 to December 2014.
Robust t-statistics, in parentheses, are reported below the coefficient
estimates. Calendar-year dummies and a constant are included in all
regressions but are not tabulated.
adequacy ratio have higher levels of future profitabil-
ity. Lastly, banks with bigger gross 10-K file sizes have
lower future ROA values, consistent with the nonfi-
nancial firm evidence of Li [2008].
The variable % Negative has a measurable eco-
nomic effect on subsequent ROA. The coefficient on
% Negative is –0.020 in column 2 while the standard
deviation for % Negative is 0.381. Thus, the economic
effect of a 1-SD increase in the number of negative
words is a 3.24% (¼–0.020  0.381/ROA mean of
0.235 in first quarter of year t þ 1) lower ROA value.
Conclusions
In this article we describe a new methodology for
measuring financial distress in U.S. banks. We use
the sentiment of the annual reports (i.e., Form
10-K) to gauge how close U.S. banks are to financial
distress. This technique is based on the fact that
managers at financially distressed banks are likely
to use a higher relative proportion of negative
words in their Form 10-K to describe their firm’s
economic situation.
We test how well our measure of financial distress,
based on the sentiment of the annual report, relates to
future values (in the subsequent year) of 4 separate
indicators of distress: distressed delisting from the
NYSE, Amex, or Nasdaq exchanges; dividend pay-
ments; percent loan loss provisions; and ROA. We
find that banks with a higher fraction of negative

words in the annual reports are more likely to have a
distressed delisting, are less likely to pay dividends,
have a higher fraction of provision for loan losses,
and a lower ROA in the near future. This relation is
robust to several specifications and holds in univariate
regressions as well in regressions with various bank
level controls such as market capitalization, capital
adequacy ratio, prior returns, and lagged values of the
dependent variables.
Our approach of measuring financial distress based
on the sentiment of the annual reports offers several
advantages as compared with existing models used by
regulators. Existing models of financial distress at U.S.
banks primarily rely on a complex combination of
several financial ratios. If bank managers are aware
that certain financial ratios are scrutinized more
closely by regulators, then this gives them the incen-
tive to “window dress” the data to meet or exceed
predetermined regulatory thresholds. Managers could
also use accounting discretion to paint a misleading
picture concerning the quality of their real-estate
assets and regulatory capital. This would result in reg-
ulators or investors using inaccurate financial data to
predict financial distress, consistent with the evidence
of Huizinga and Laeven [2012] and Rajan, Seru, and
Vig [2015]. In addition, existing methodologies of pre-
dicting bank distress may miss extreme events, when
banks are subject to catastrophic losses, and when
banks that met or exceeded regulatory thresholds may
feel or become distressed.
In the aftermath of the financial crisis of
2007–2008, there is increasing interest in attempting
to identify financial institutions that are beginning to
experience financial distress so that regulators can
respond quickly, when and if necessary. These new
methodologies were required, in-part, because existing
approaches of predicting financial distress at U.S.
financial institutions relied primarily on the capital
adequacy ratio and other financial ratios that were no
longer informative. For example, during the financial
crisis even well capitalized financial institutions
became financially distressed. Our results suggest that
regulators can easily add a new technique to their
array of tests and use annual report sentiment to help
identify banks that are in financial distress. This
methodology can supplement existing analytical tech-
niques as an additional check on the health of individ-
ual banks or the general well-being of the banking
sector. If negative tone becomes a measure of bank
viability, bank managers might similarly be tempted
to abstain from documenting negative information in
their financial filings, however, the threat of
JOURNAL OF BEHAVIORAL FINANCE 11
subsequent shareholder lawsuits creates a strong
incentive to preclude such evasion.
Acknowledgments
The authors thank Thomas Cosimano, Paul Gao, John
Holland, Peter Kelly, Jerry Langley, an anonymous referee,
and seminar participants at the University of Miami,
HKUST, University of Minnesota, and York University for
helpful comments.
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 JOURNAL OF BEHAVIORAL FINANCE 13

Appendix A. Definitions of the variables used in the article

% Negative Percentage of words in the 10-K that are on the Loughran and McDonald [2011] negative word list (total num-
ber of negative words in the Form 10-K / total number of Form 10-K words). Examples of negative words
include loss, losses, adverse, and restated.
Dependent Variables
Distressed Delisting Dummy A dummy variable set to 1 if the bank has a distressed CRSP delisting within 3 subsequent years of the 10-K
filing date, else 0. The CRSP delisting variable, dlstcd, must be in the range of 300–599 to be considered a
distressed delisting.
Dividend Dummy A dummy variable set to 1 if the bank issues dividends in the subsequent year, else 0.
% Loan Losses The ratio of provisions for loan losses scaled by total loans. Both items are obtained from the FRY-9C database.
The variable is winsorized at the 1% level.
ROA The ratio of net income scaled by total assets. Both items are obtained from the FRY-9C database. The variable
is winsorized at the 1% level.
Control Variables
Capital Adequacy The variable is (Tier 1 capital þ Tier 2 capital)/ total assets at the time of the 10-K filing.
Market Capitalization The variable is stock price multiplied by shares outstanding (in thousands of dollars) as of 2 days before the
10-K filing date.
Gross File Size This variable is file size in megabytes of the SEC EDGAR “complete submission text file” for the 10-K filing.
Loughran and McDonald [2014] recommend using the file size of the 10-K as an easily calculated proxy for
document readability.
Excess Prior Returns The buy-and-hold firm returns minus the buy-and-hold returns of the CRSP value-weighted index over an iden-
tical period in the year before the 10-K filing date.