Loan Loss Provisioning and Economic Slowdowns: Too much, Too Late? By Luc Laeven and Giovanni Majnoni Finance Forum 2002 June 19-21, 2002

A policy question… Traditional “capital crunch” effects may set in and they may be stronger for emerging economies; Risk-weighted capital has already cyclical effects that may be compounded by high level of provisioning in bad times. Should banks make provisions when losses have already materialized? affecting capital?

PDF of credit losses: expected and unexpected losses, capital and LLP.

… and possible answers LLP regulation in Spain: build up of LLR in good times has income smoothing effects; Minimum capital requirements should not lead to minimum LLR requirements; To consider general loan loss reserves simply as a component of tier II capital may not be appropriate.

Some positive aspects of LLP from a regulatory perspective If loan loss reserves are required to be held on average over a maintenance period (increased during upswings and depleted during downswings) they may act as a buffer protecting capital from negative shocks (Spain). This behavior would better reflect the true underlying profitability of a bank. Banks would set aside every year (as provisions) the income from credit risk premia, apparently smoothing reported bank earnings over time but in reality properly accounting for expected costs.

Some positive aspects of LLP from a regulatory perspective Volatility of reported earnings can be shown to derive purely from accounting practices (i.e. from an omitted registration of costs that inflates earnings) and has no economic determinants. Loan loss provisions are easier to measure than capital (no correlation issues, smaller confidence intervals);

Has income smoothing unequivocal beneficial effects? Due to the presence of information imperfections two positions emerge: “Accounting profession” perspective: –Income smoothing is bad because it introduces judgmental modifications of firm earnings that reduce the comparability of results across firms “Economic profession” perspective: –Income smoothing has evident benefits for risk averse agents.

Do LLP follow an income smoothing pattern? 1.For the US, Greenwalt and Sinkey (1988) found an average positive association between LLP and operating profits coherent with an income smoothing pattern; 2.More recently an empirical analysis of evidence for European countries participating in the EMU (ECB, 2002) found a different patterns across countries but on average a lack of income smoothing patterns.

The empirical questions 1.Income smoothing: positive association of loan loss provisions with pre-provision income (Do banks set aside more in good times?); 2.Positive association of LLP with GDP growth (Do banks condition LLP on the macroeconomic conditions?); 3.Positive association of LLP with bank loan growth (Do ex- ante risk management consideration condition LLP policies?); Income smoothing is not the only indicator of the overall cyclical behavior of LLP we should look for :

The testing strategy We adopt two empirical specifications to test for the robustness of our findings to different model specification: a static specification; a dynamic specification to test for the nature of dynamic adjustment of LLP.

The data 1.Banks’ balance sheets and income statements from Bankscope; 2.Country-level variables such as GDP from World Development Indicators, World Bank 3.1,419 banks from 45 countries 4.Sample period: ,176 bank-year observations 6.“Good” distribution across years and regions

Distribution of bank-year observations

The testing strategy Separate tests: 1.For the sample as a whole; 2.For regional groups of countries: Europe, US, Japan, Latin America, Asia; 3.With and without a non-linear income term. Purpose: 1.Verify differentiated patterns across regions; 2.Avoid the average results being affected by countries with more bank/years observations; 3.Test for behavior of more profitable banks.

Static specification

Main results: Static Specification 1.On average we observe an income smoothing behavior: + 1 st. dev. of earnings leads to of the provision ratio to total assets… 2.… but the interaction term related to periods of negative profitability captures a significant anti- cyclical pattern at low or negative profits. 3.… and real GDP growth is negatively associated with provisions: + 1 st. dev. of GDP growth leads to of the provisions ratio to total assets; 4.… and real loan growth is negatively related to provisions: +1 loan growth st. dev. leads to of the provisions ratio to total assets;

Static specification with regional regressions

Main results: Static specification with regional regressions 1.Only Asia has a clearly anti-cyclical average provisioning pattern; 2.But banks in all the regions – and in Japan and in Asia especially - have an anti-cyclical pattern for low levels of income; 3.The negative association between LLP and credit growth is confirmed for all the regions and is strongest in Japan; 4.Similarly a negative association with GDP growth is found for all the regions but for Latin America.

Dynamic Specification

Main results: Dynamic specification At the aggregate level previous finding appear confirmed; At the regional level: The income smoothing hypothesis is rejected for Asia and for Japan; Banks located in Japan and in Asia have an especially, anti- cyclical pattern for low levels of income; The negative association between LLP and credit growth is confirmed for Europe, Japan and Latin America; Similarly a negative association with GDP growth is confirmed for US, Japan, and Latin America. Time dummies show a differentiated patterns across regions with a reduction in the US case that is consistent with changes in regulation.

Conclusions 1.Generalized evidence of anti-cyclical pattern of provisions has emerged on average and across geographical regions; 2.Most of the time anti-cyclical patterns are generated by an inadequate level of provisioning in the good phases of the cycle consistent with a delayed recognition of potential losses; 3.Independently from income smoothing at the bank level, the empirical evidence points to an inadequate consideration of risk elements (as proxied by loan growth) and macro conditioning factors (GDP growth). 4.Each region has appeared to be exposed to at least one of the three indicators of anti-cyclical pattern of LLP.

Conclusions Overall the empirical evidence supports the need of additional regulatory effort to insure that a more timely provisioning for loan losses may insulate more effectively bank capital from negative shocks during downturns.