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Economic Loan Loss Provision and Expected Loss


  • Stefan Hlawatsch

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

  • Sebastian Ostrowski

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


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.

Suggested Citation

  • Stefan Hlawatsch & Sebastian Ostrowski, 2009. "Economic Loan Loss Provision and Expected Loss," FEMM Working Papers 09013, Otto-von-Guericke University Magdeburg, Faculty of Economics and Management.
  • Handle: RePEc:mag:wpaper:09013

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    References listed on IDEAS

    1. Mario Quagliariello, "undated". "Banks' Performance over the Business Cycle: A Panel Analysis on Italian Intermediaries," Discussion Papers 04/17, Department of Economics, University of York.
    2. 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.
    3. Kim, Daesik & Santomero, Anthony M., 1993. "Forecasting required loan loss reserves," Journal of Economics and Business, Elsevier, vol. 45(3-4), pages 315-329.
    4. 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.
    5. 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.
    6. 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.
    7. 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.
    8. 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.
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    More about this item


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

    JEL classification:

    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting

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