Shareholder shocks and loan loss provisions in Central European banks

Abstract

We examine loan loss provisions (LLP) in banks as a previously unexplored channel of shock transmission between foreign banks and their subsidiaries. We focus on discretionary LLP, controlling for the underlying credit risk and previously created loan loss reserves. We study negative and positive shocks in order to account for LLP cyclicality. Using a sample of 71 Central European foreign-owned banks, we find that shocks suffered by shareholders are connected to changes of discretionary LLP at subsidiary banks. Moreover, the type of shareholder shock matters. Banking sector and shareholder-specific adverse shocks are associated with higher LLP. Negative macroeconomic shocks are paired with a lower level of LLP, but this effect disappears if the shock is wide and also encompasses banking sectors or capital markets. In addition, we find that positive shocks to shareholder profitability incur higher discretionary LLP. Our findings contribute to the shock transmission literature, which to date has mostly focused on the consequences of shareholder shocks for subsidiary bank loan supply. We demonstrate that LLP can also be affected.