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Do Banks provision for bad loans in good times? empirical evidence and policy implications

  • Cavallo, Michele
  • Majnoni, Giovanni
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    Recent debate about the pro-cyclical effects of bank capital requirements, has ignored the important role that bank loan loss provisions play in the overall framework of minimum capital regulation. It is frequently observed that under-provisioning, due to inadequate assessment of expected credit losses, aggravates the negative effect of minimum capital requirements during recessions, because capital must absorb both expected, and unexpected losses. Moreover, when expected losses are properly reflected in lending rates, but not in provisioning practices, fluctuations in bank earnings magnify true oscillations in bank profitability. The relative agency problems faced by different stakeholders, may help explain the prevailing, and often unsatisfactory institutional arrangements. The authors test their hypotheses with a sample of 1,176 large commercial banks - 372 of them in non-G10 countries - for the period 1988-99. After controlling for different country-specific macroeconomic, and institutional features, they find robust evidence among G10 banks, of a positive association between loan loss provisions, and banks'pre-provision income. Such evidence is not confirmed for non-G10 banks, which on average, provision too little in good times, and are forced to increase provisions in bad times. The econometric evidence shows that the protection of outsiders'claims - the claims of minority shareholders in common law countries, and of fiscal authorities in countries with high public debt - on bank income, has negative effects on the level of bank provisions.

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    Paper provided by The World Bank in its series Policy Research Working Paper Series with number 2619.

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    Date of creation: 30 Jun 2001
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    Handle: RePEc:wbk:wbrwps:2619
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    1. Paul H. Kupiec, 1995. "Techniques for verifying the accuracy of risk measurement models," Finance and Economics Discussion Series 95-24, Board of Governors of the Federal Reserve System (U.S.).
    2. James T. Moser, 1998. "Credit derivatives: just-in-time provisioning for loan losses," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q IV, pages 2-11.
    3. Claudio Borio & Craig Furfine & Philip Lowe, 2001. "Procyclicality of the financial system and financial stability: issues and policy options," BIS Papers chapters, in: Bank for International Settlements (ed.), Marrying the macro- and micro-prudential dimensions of financial stability, volume 1, pages 1-57 Bank for International Settlements.
    4. Maria Concetta Chiuri & Giovanni Ferri & Giovanni Majnoni, 2000. "The Macroeconomic Impact Of Bank Capital Requirements In Emerging Economies: Past Evidence To Assess The Future," series 0002, Dipartimento di Scienze Economiche e Metodi Matematici - Università di Bari, revised Sep 2000.
    5. Rafael LaPorta & Florencio Lopez-de-Silanes & Andrei Shleifer & Robert W. Vishny, . "Law and Finance," Working Paper 19451, Harvard University OpenScholar.
    6. Larry D. Wall & Timothy W. Koch, 2000. "Bank loan-loss accounting: a review of theoretical and empirical evidence," Economic Review, Federal Reserve Bank of Atlanta, issue Q2, pages 1-20.
    7. repec:imf:imfpdp:9606 is not listed on IDEAS
    8. International Monetary Fund, 2000. "Loan Review, Provisioning, and Macroeconomic Linkages," IMF Working Papers 00/195, International Monetary Fund.
    9. Holmstrom, Bengt & Tirole, Jean, 2000. "Liquidity and Risk Management," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(3), pages 295-319, August.
    10. Kim, Daesik & Santomero, Anthony M., 1993. "Forecasting required loan loss reserves," Journal of Economics and Business, Elsevier, vol. 45(3-4), pages 315-329.
    11. Timothy W. Koch & Larry D. Wall, 1999. "Banks' discretionary loan loss provisions: how important are constraints and asymmetries?," Proceedings 618, Federal Reserve Bank of Chicago.
    12. Simon Kwan & Randy O'Toole, 1997. "Recent developments in loan loss provisioning at U.S. commercial banks," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue jul25.
    13. Hesna Genay, 1998. "Assessing the condition of Japanese banks: how informative are accounting earnings?," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q IV, pages 12-34.
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