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Economic Loan Loss Provision and Expected Loss

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  • Stefan Hlawatsch

    ()
    (Faculty of Economics and Management, Otto-von-Guericke University Magdeburg)

  • Sebastian Ostrowski

    ()
    (Faculty of Economics and Management, Otto-von-Guericke University Magdeburg)

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    Abstract

    The intention of a loss provision is the anticipation of credit's expected losses by adjusting the book values of the credits. Furthermore, this loan loss provision has to be compared to the expected loss according to Basel II and if necessary, equity has to be adjusted. This however assumes that the loan loss provision and the expected loss are comparable, which is only valid conditionally in current loan loss provisioning methods according to IAS. The provisioning and accounting model developed in this paper overcomes the before mentioned shortcomings and is consistent with an economic rationale of expected losses. We introduce a de¯nition of expected loss referring to the whole maturity of the loan and show that this measure can be reasonably compared with loan loss provisions. Additionally, this model is based on a close-to-market valuation of the loan. Suggestions for changes in current accounting and capital requirement rules are provided.

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    File URL: http://www.ww.uni-magdeburg.de/fwwdeka/femm/a2009_Dateien/2009_13.pdf
    File Function: First version, 2009
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    Bibliographic Info

    Paper provided by Otto-von-Guericke University Magdeburg, Faculty of Economics and Management in its series FEMM Working Papers with number 09013.

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    Length: 21 pages
    Date of creation: Apr 2009
    Date of revision:
    Handle: RePEc:mag:wpaper:09013

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    Keywords: loan loss provision; expected loss; IAS; Basel II;

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    1. George J. Benston & Larry D. Wall, 2005. "How should banks account for loan losses?," Economic Review, Federal Reserve Bank of Atlanta, issue Q4, pages 19-38.
    2. R. M. Cyert & H. J. Davidson & G. L. Thompson, 1962. "Estimation of the Allowance for Doubtful Accounts by Markov Chains," Management Science, INFORMS, vol. 8(3), pages 287-303, April.
    3. Laeven, Luc & Majnoni, Giovanni, 2003. "Loan loss provisioning and economic slowdowns: too much, too late?," Journal of Financial Intermediation, Elsevier, vol. 12(2), pages 178-197, April.
    4. Ahmed, Anwer S. & Takeda, Carolyn & Thomas, Shawn, 1999. "Bank loan loss provisions: a reexamination of capital management, earnings management and signaling effects," Journal of Accounting and Economics, Elsevier, vol. 28(1), pages 1-25, November.
    5. Gunther Gebhardt, 2008. "Accounting for credit risk: are the rules setting the right incentives?," International Journal of Financial Services Management, Inderscience Enterprises Ltd, vol. 3(1), pages 24-44.
    6. Mario Quagliariello, . "Banks' Performance over the Business Cycle: A Panel Analysis on Italian Intermediaries," Discussion Papers 04/17, Department of Economics, University of York.
    7. R. M. Cyert & Robert M. Trueblood, 1957. "Statistical Sampling Techniques in the Aging of Accounts Receivable in a Department Store," Management Science, INFORMS, vol. 3(2), pages 185-195, January.
    8. Kim, Daesik & Santomero, Anthony M., 1993. "Forecasting required loan loss reserves," Journal of Economics and Business, Elsevier, vol. 45(3-4), pages 315-329.
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