The impact of calendar provisioning on bank strategies

Calendar provisioning aims to prevent banks from delaying the recognition of NPLs losses. It establish the minimum percentage of loss coverage requirements, based on the time elapsed since the default classification. This paper provides a micro–founded model of the impact of calendar provisioning on two bank strategies: Active (recapitalize when the leverage constraint binds) and Passive (sell NPLs when the leverage constraint binds). Loans evolve according to a Geometric Brownian Motion augmented with a Poisson process to capture the probability of rules enforcement. As banks management of their NPLs involve irreversible decisions our analysis use a real option framework. We obtain a closed-form solution of the option values of the two strategies which allows us to calibrate their impact, that of key parameters, and to obtain insights that deliver testable propositions. An increase in the probability of calendar provisioning makes NPLs sales more likely and speeds their sales up. When the bank has a low cost of equity or faces a low probability of intervention it prefers the Active strategy. An increase in the bank’s NPL depreciation rate may induce the bank to prefer the Active to the Passive strategy, leading to NPLs sales with lower probability. The policy implications are that while the regulator can affect NPLs sales via the probability of enforcing calendar provisioning, it must also take into account bank specific circumstances since the cost of equity and the NPLs depreciation rate are specific to each bank and each jurisdiction.