Do_Banks_Provision_for_Bad_Loans key artile - Do Banks...

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Do Banks Provision for Bad Loans in Good Times? Empirical Evidence and Policy Implications Michele Cavallo* and Giovanni Majnoni** 1 First Draft: February 2001 Abstract: The recent debate over the pro-cyclical effects of capital regulation has overlooked the important role that bank loan provisions play in the overall minimum capital regulatory framework. Inadequate assessment of expected credit losses leads to under-provisioning and implies that capital has to absorb both expected and unexpected losses, aggravating the negative impact of minimum capital requirements during recessions. In addition, when expected losses are properly reflected in lending rates but not in provisioning practices banks earnings fluctuations magnify true bank profitability oscillations. The agency problems faced by different bank stakeholders (outsiders versus insiders) may help to explain the prevailing and often unsatisfactory institutional arrangement. We test our hypothesis over a sample of 1176 large commercial banks, 372 of which from non-G10 countries, over the period 1988-1999. After controlling for different country specific macroeconomic and institutional features, we find robust evidence of a positive association between loan loss provisioning and banks EBTDA for G10 banks. Such evidence is not confirmed for non-G10 banks, that on average provision too little in good times and are forced to increase provisions in bad times. We also find that the protection of “outsiders” claims over banks’ income has negative effects on loan loss provisioning. JEL classification numbers: G21, G28. Keywords: banks, bank regulation, loan loss provisions * Michele Cavallo, New York University, Dept. of Economics, 269 Mercer St. New York, NY, 10003. Tel (212) 998 8972; Fax: (212) 995 4186; email: [email protected] . ** Giovanni Majnoni, corresponding author, The World Bank, 1818 H Street, NW, Washington, DC, 20433. Tel: (202) 458 7542; Fax: (202) 522 2031; email: [email protected] .
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1 1. Introduction 2 Pro-cyclical effects of risk-based capital have been a relevant element of concern in the ongoing debate about new bank capital requirements. The deterioration of banks’ asset quality during cyclical downturns, in fact, generates higher capital requirements exactly when capital may be more expensive or simply unavailable for weaker institutions. When capital shortages are faced by banks accounting for a large share of total lending to the economy the resulting credit contraction may have systemic implications 3 . This paper suggests that cyclical shortages of banks’ capital may not only be due to the risk based regulation of bank capital but most prominently to the lack of risk based regulation of banks’ loan loss provisioning practices. We focus on banks’ loan loss provisions and suggest that capital shortages may often be caused by inadequate provisioning. The blame for pro-cyclical effects associated with capital shortages should therefore shift to some extent from the content of currently proposed capital regulation to
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This note was uploaded on 12/04/2011 for the course FIN 4231 taught by Professor Aimanissaeva during the Fall '11 term at Kazakhstan Institute of Management, Economics and Strategic Research.

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Do_Banks_Provision_for_Bad_Loans key artile - Do Banks...

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