What Drives Heterogeneity of Cyclicality of Loan-Loss Provisions in the EU?

Abstract

In the theory of banking, prudent risk management is perceived as being necessary to curb the excessive procyclicality evident in many activities of banks. As banks differ in their risk-management approaches, their sensitivity to the business cycle is also far from uniform. This paper aims to identify the sources of such diverse relationships between loan-loss provisions (LLP) and the business cycle. Using the two-step system GMM Blundell and Bond estimator on a panel database of over 3000 banks operating in the European Union (EU) in 1996–2011, this study documents a large cross-bank and cross-country variation in the relationship between loan-loss provisions and the business cycle and explores bank-management specific, bank-activity specific and country-specific features that explain this diversity in the EU. Our results indicate that LLP in large, publicly-traded and commercial banks, as well as in banks reporting consolidated statements, are more procyclical. More restrictive capital standards and better investor protection are linked with weakened procyclicality of LLP. Neither official supervision nor private-market monitoring is effective in reducing the procyclicality of LLP. Thus, our study supports the view that microprudential supervision is not sufficient to combat the procyclicality of the banking sector, and therefore should be supplemented with macroprudential supervision. Moreover, as large banks LLP are definitely more procyclical, we provide empirical support for the post-crisis restrictive regulations (Basel III and macroprudential policy) of systemically-important financial institutions (SIFIs). This study also lends empirical support to the hypothesis that more income smoothing and greater coverage of expected loan losses reduce the procyclicality of LLP.