Do Banks Provision for Bad Loans in Good Times? Empirical Evidence and Policy Implications

Abstract

(June 2001) The general recognition that bank capital should provide a buffer for 'unexpected' losses assumes that 'expected' losses are considered in setting loan loss provisions. Failure to provide coherent and internationally accepted regulation of provisions for loan losses reduces the usefulness of minimum capital regulations, especially in emerging economies. 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 underprovisioning, 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. Cavallo and Majnoni 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. This paper--a product of the Financial Sector Strategy and Policy Department--is part of a larger effort in the department to study the impact of financial regulation on economic development. The authors may be contacted at mc399@is.nyu.edu or gmajnoni@worldbank.org