Procyclicality Of Loan Loss Provisions Research Articles

How Does Macroprudential Policy Impact Bank Risk-Taking and Profitability: Evidence from Indian Commercial Banks

ABSTRACT This study analyses the impact of macroprudential policy (MaPP) on Indian banks’ risk-taking and profitability. Using commercial bank data from 2004–05 to 2019–20, the risk-taking is measured by Z-score, and loan loss provision and profitability by return on average assets and return on average equity, respectively. Employing the panel system-GMM technique, the study finds. (1) MaPP mitigates bank risk-taking by enhancing the bank’s stability and reducing the procyclicality of loan loss provisions. (2) MaPP is found to have a positive impact on bank profitability. (3) MaPP is found to be more effective in the context of private and foreign banks as compared to nationalized banks. (4) Within the macroprudential toolkit, reserve requirements and risk-weights are found to have a positive impact on risk-taking and profitability, whereas provisioning requirements are found to have a negative impact.

Impacts of the Expected Credit Loss Model on Pro-Cyclicality, Earnings Management, and Equity Management in the Portuguese Banking Sector

This article delves into the pro-cyclicality of loan loss provisions (LLPs) and earnings management, along with equity management, in Portuguese banks against the backdrop of implementing the IFRS 9’s expected credit loss (ECL) model. It concentrates on how LLPs mirror economic cycles and financial management practices, providing valuable insights into the operational dynamics of the Portuguese banking sector, marked by distinct economic and regulatory challenges. The research examined a sample of five Portuguese commercial banks, chosen from a group of seventeen in the Portuguese Banking Association. Data spanning from 2013 to 2022 were manually gathered. A multiple linear regression model was employed to scrutinize the relationship between LLPs and variables indicative of economic cycles and the earnings and equity management. The methodology use was a multiple linear regression model. The analysis indicates a pro-cyclicality in LLPs within the Portuguese context, with a positive response of LLPs to economic indicators like unemployment. Contrarily, the extent of earnings and equity management under the ECL model was less marked compared to the incurred credit loss (ICL) model, suggesting the impact of more stringent regulatory measures. The research corroborates the pro-cyclicality of LLPs in Portuguese banks under the ECL framework, underscoring the necessity for ongoing monitoring and refinement of models for forecasting and recognizing credit losses. The findings point to an area for improvement in financial management practices, despite regulatory enhancements, to promote transparency and ensure financial stability.

Procyclicality of the Financial Systems in Emerging Economies

This research aimed at examining the procyclicality of financial systems in emerging economies, with a particular focus on the role of loan loss provisions. In total, 318 articles were initially retrieved, which after applying the inclusion and exclusion criteria, led to final selection of 15 relevant and latest articles. From the literature reviews, it was found that financial systems in emerging economies exhibit procyclicality behaviour, corresponding to economic cycles. Loan loss provisions, as a key component of bank financial statements, play a significant role in the procyclicality of lending activity. Studies from various countries, including African economies, Jordan, South Africa, Kenya, and the Gulf Cooperation Council (GCC) countries, reveal both pro- and counter-cyclical patterns of loan loss provisions. The degree of procyclicality is influenced by factors such as bank capitalization, bank size, competition, business cycles, macroprudential policies, and the regulatory and supervisory framework. Notably, the findings suggest that policy makers and banking authorities need to address the procyclicality of loan loss provisions and implement effective macroprudential policies to mitigate the impact of economic cycles on lending activities. The study recommends that financial institutions should develop robust risk management practices to better manage economic fluctuations and reduce the impact of procyclicality.

Procyclicality of loan-loss provisions and competitive environment – a global perspective

PurposeDespite the extensive debate on the impact of bank competition on risk-taking, there is no evidence of its role in procyclicality of loan-loss provisions (LLPs). The purpose of this study is to find out what is the role of competition in the procyclicality of LLPs.Design/methodology/approachUsing over 70,000 bank-level observations in 103 countries in 2004–2015 and the LLPs model, this study interacts competition with business cycle to check what is the effect of competition on procyclicality of LLPs.FindingsThis study finds that intense competition is associated with more procyclicality of LLPs. Increased procyclicality of LLPs in a more competitive environment is binding for high-income countries. The opposite effect is shown for low-income countries.Research limitations/implicationsFuture research can be extended by testing the role of additional factors – such as regulations, supervision or institutional protection of shareholders' rights, in the association between procyclicality and competition.Practical implicationsThe main message of this paper is that the competitive environment changes the procyclicality of LLPs. The results are important from the point of view of the COVID-19 pandemic because government interventions during lockdowns will affect competition in the banking industry and in other industries of the economy.Originality/valueThis paper contributes to the extant research in three dimensions. First, it shows that competition is an important factor behind procyclicality of LLPs. Second, it adds to the research on the links between competition and financial stability. Third, it shows that the link between competition and procyclicality of LLPs depends on the economic development of the country in which the banks are located.

IFRS 9 and its behavior in the cycle: The evidence on EU countries

AbstractThe purpose of this paper is to analyze empirically the behavior of expected loan loss provisions during the economic cycle. The provisioning rules under IFRS 9 require the creation of reserves to cover expected credit losses, were anticipated to act countercyclically, and thus replaced the rules under IAS 39, which are widely presumed to have a procyclical impact. Observing the dynamics of the economic cycle during the economic downturn resulting from the COVID restrictions, a panel regression was performed to test the hypothesis that loan loss provisioning rules under IFRS 9 have a procyclical impact. The hypothesis was not rejected on the basis of a sample of the member countries of the European Union for the period of 1Q 2015 – 3Q 2020. Since the conclusions about procyclicality of loan loss provisions under IFRS 9 might be sensitive to the choice of models applied by the banks or to the assumptions applied to forward‐looking information used in the models, there are certain areas that supervisory and regulatory authorities might look into to increase the quality of ECL models and their predictive power and help to eliminate potential triggers of procyclicality.

The Procyclicality of Banking: Evidence from the Euro Area

Loan loss provisions in the euro area are negatively related to GDP growth, i.e., they are procyclical. Loan loss provisions tend to be more procyclical at larger and better capitalized banks. The procyclicality of loan loss provisions can explain about two-thirds of the variation in bank capitalization over the business cycle. We estimate that provisioning procyclicality in the euro area is about twice as large as in other advanced economies. This difference reflects a larger procyclicality of provisioning in euro area countries already prior to euro adoption and the divergent growth experiences of euro area countries following the global financial crisis.

THE JOINT EFFECT OF BORROWER TARGETED MACROPRUDENTIAL INSTRUMENTS AND CAPITAL REGULATIONS ON PROCYCLICALITY OF LOAN-LOSS PROVISIONS

We analyze the effects of macroprudential policy and micro-prudential capital regulations on the procyclicality of loan-loss provisions, using individual bank information from over 65 countries. In this study we test whether the interaction between borrower targeted macroprudential policy instruments and restrictive micro-prudential capital regulations tends to adjust the countercyclical effect of borrower targeted instruments and capital regulations. To this end we apply the two-step GMM estimator with robust standards errors. Our analysis implies that merging restrictive borrower targeted instruments and capital regulations tends to weaken the countercyclical effect of borrower targeted macroprudential policy instruments and restrictive capital adequacy regulations. This effect depends on size, and is stronger in large banks.

Income smoothing behavior and the procyclical effect of loan loss provisions in Islamic banks

Purpose This study aims to test whether loan loss provisions in Islamic banks is procyclical by explicitly examining the link between non-discretionary provisions and loan growth. In the next stage, this paper tests whether the link between non-discretionary provisions and loan growth is conditional on bank capitalization and lending. This is to identify whether bank-specific factors affect the procyclicality of non-discretionary provisions and whether such procyclicality can be explained by income smoothing in banks with different capitalization and loan profiles. Design/methodology/approach This study is conducted in four stages. The first stage identifies the determinants of loan loss provisions. The second stage investigates whether income smoothing is affected by capitalization and lending activities. In the third stage, the link between non-discretionary provisions and loan growth is examined. In the fourth stage, this paper tests whether the link between non-discretionary provisions and loan growth is affected by bank capitalization and lending. A two-way panel-fixed effect model is used. Findings Non-discretionary provisions are procyclical, particularly for banks with lower capitalization and lending activities, because such banks do not conduct income smoothing. Specifically, banks with lower capitalization experience a decline in loan growth when non-discretionary provisions to cover credit risk increase. Research limitations/implications The dataset used in this study follows Soedarmono et al. (2017) and does not enable to differentiate types of financing products in Islamic banks that may exacerbate or mitigate the procyclicality of non-discretionary provisions. Originality/value This paper extends prior literature on the procyclicality of loan loss provisions by specifically investigating the influence of non-discretionary provisions on loan growth in Islamic banks and whether such relationship depends on the role of income smoothing undertaken by banks with different levels of capitalization and lending. This paper builds on the work of Soedarmono et al. (2017) in which they do not explicitly examine the relationship between loan loss provisions and loan growth.

The Procyclicality of Banking: Evidence from the Euro Area

Loan loss provisions in the euro area are negatively related to GDP growth, i.e., they are procyclical. Loan loss provisions tend to be more procyclical at larger and better capitalized banks. The procyclicality of loan loss provisions can explain about two-thirds of the variation of bank capitalization over the business cycle. We estimate that provisioning procyclicality in the euro area is about twice as large as in other advanced economies. This difference reflects a larger procyclicality of provisioning in euro area countries already prior to euro adoption, and the divergent growth experiences of euro area countries following the global financial crisis.

The procyclicality of loan loss provisions in Islamic banks

From a sample of Islamic banks around the world from 1997 to 2012, this paper examines whether loan loss provisioning in Islamic banks is procyclical. Our empirical findings highlight that loan loss provisioning in Islamic banks remains procyclical, although the ‘expected’ loan loss model (E-LLM) has been implemented for Islamic banks in several countries. A closer investigation further documents that Islamic banks also use loan loss provisions for discretionary managerial actions, especially related to capital management in which loan loss reserves and provisions are inflated when bank capitalization declines. Eventually, this paper highlights that higher capitalization can mitigate the procyclicality of loan loss provisions in Islamic banks. In other words, loan loss provisioning becomes countercyclical for Islamic banks with higher capitalization. This paper therefore casts doubts on the adoption of the E-LLM for Islamic banks to promote countercyclical effects, because the E-LLM may be influenced by managerial discretion, including opportunistic capital management using loan loss provisions that may undermine the importance of maintaining bank capitalization.

IAS 39, income smoothing, and pro-cyclicality: evidence from Hong Kong banks

Purpose The purpose of this study is to investigate the impact of International Accounting Standard 39 (IAS 39) on income-smoothing activities and pro-cyclical behavior through loan loss provisions using a sample of Hong Kong banks. Design/methodology/approach Fixed effects estimator is used, and the analysis covers the period from 2000 to 2009. Findings The results suggest that Hong Kong banks engage less in income-smoothing activity after they comply with the IAS 39. No evidence supports loan loss provisions of Hong Kong banks exhibiting more pro-cyclical behavior after IAS 39 adoption. Research limitations/implications Compliance with IAS 39 should improve the quality of bank financial reporting. The reduction in income-smoothing activities among Hong Kong banks after IAS 39 adoption fairly supports the effectiveness of International Financial Reporting Standard (IFRS) and countries that have yet to comply with IFRS may take action to apply the standards. Bank regulators should take pro-active action in addressing the issue of pro-cyclicality of loan loss provisions, as IAS 39 focuses more on improving the financial information quality, while pro-cyclicality is associated with the economic cycles. Originality/value Hong Kong banking industry is unique, as it was among the first IFRS adopters in the East Asia region and it has its own legal framework for developing accounting standards. The results of this study are expected to shed some light on the effects of IAS 39 adoption on income smoothing and pro-cyclicality of banks in the East Asia region, where the accounting cultural value dimensions and institutional structures are different than that of European countries.

The Procyclicality of Loan Loss Provisions in Islamic Banks: Do Managerial Discretions Matter?

This paper is the first to examine whether the loan loss provisioning behavior of Islamic banks is procyclical. From a dynamic panel data methodology, the empirical results show that loan loss provisioning in Islamic banks is indeed procyclical, as higher economic growth leads to a decline in loan loss provisions. A closer investigation is also conducted to examine whether capital management, income smoothing, or signaling behavior can alter the procyclicality of loan loss provisions. Specifically, our results document that only capital management behavior can overcome the procyclicality of loan loss provisions. This paper therefore advocates the importance of strengthening discretionary behavior in Islamic banks in terms of capital management using loan loss provisions, particularly during economic boom.

The Procyclicality of Loan Loss Provisions in Islamic Banks

From a sample of Islamic banks around the world from 1997 to 2012, this paper examines whether loan loss provisioning in Islamic banks is procyclical. Our empirical findings highlight that loan loss provisioning in Islamic banks remains procyclical, although the ‘expected’ loan loss model (E-LLM) has been implemented for Islamic banks in several countries. A closer investigation further documents that Islamic banks also use loan loss provisions for discretionary managerial actions, especially related to capital management in which loan loss reserves and provisions are inflated when bank capitalization declines. Eventually, this paper highlights that higher capitalization can mitigate the procyclicality of loan loss provisions in Islamic banks. In other words, loan loss provisioning becomes countercyclical for Islamic banks with higher capitalization. This paper therefore casts doubts on the adoption of the E-LLM for Islamic banks to promote countercyclical effects, because the E-LLM may be influenced by managerial discretion, including opportunistic capital management using loan loss provisions that may undermine the importance of maintaining sufficient bank capitalization.

The Effects of Capital on Bank Lending in EU Large Banks The Role of Procyclicality, Income Smoothing, Regulations and Supervision

This paper aims to find out what the impact is of bank capital ratios on loan supply in the EU and what factors explain the potential diversity of this impact. Applying the Blundell and Bond (1998) two step GMM estimator, we show that, in the EU context, the role of capital ratio for loan growth is stronger than previous literature has found for other countries. Our study sheds some light on whether procyclicality of loan loss provisions and income smoothing with loan loss provisions contribute to procyclical impact of capital ratio on loan growth. We document that loan growth of banks that have more procyclical loan loss provisions and that engage less in income smoothing is more sensitive to capital ratios. This sensitivity is slightly increased in this sample of banks during contractions. Moreover, more restrictive regulations and more stringent official supervision reduce the magnitude of the effect of capital ratio on bank lending. Taken together, our results suggest that capital ratios are an important determinant of lending in large EU banks.

Cross-country linkages as determinants of procyclicality of loan loss provisions

Procyclicality in banking may result in financial instability and therefore be destructive to economic growth. The sensitivity of different banking balance sheet and income statement variables to the business cycle is diversified and may be prone to increasing integration of financial markets. In this paper, we address the problem of the influence of financial integration on the transmission of economic shocks from one country to another and consequently on the sensitivity of loan loss provisions (LLPs) to the business cycle. The application of the seemingly unrelated regression equations (SURE) approach to 13 OECD countries in 1995–2009 shows that the procyclicality of LLPs is statistically significant almost in the whole sample of countries. Regardless of the econometric specification, the income-smoothing, capital management and risk management hypotheses are hardly supported by the data. However, in SURE specification, the relationship of bank-specific variables is of higher statistical significance than in the country regression approach. Hence, cross-country interconnectedness is not only economically, but also empirically important when analyzing cross-country diversifications of LLPs.

Loan Loss Accounting Rules across the Globe: What do we Know?

A number of empirical studies in recent years have used cross-country data to analyze topics related to the procyclicality of loan loss provisions. However, surprisingly little is known about countries' underlying local GAAP provisioning rules. In this study, we extend the knowledge on loan loss accounting across the globe in three different ways: First, we shed light on the distribution of different characteristics of more than 150 local GAAP loan loss accounting regimes across the globe using data from the World Bank's Bank Regulation and Supervision Survey. Second, we use these data to develop indices that reflect if a provisioning regime follows an incurred loss model or allows banks to take account of expected losses. Third, we group countries, e.g. by development status or continental region, and examine patterns in provisioning rules across these groups. Fourth, we conduct our own survey among eleven central banks which is intended to provide a more comprehensive understanding of provisioning regimes. Generally, we find considerable heterogeneity in the structure of provisioning rules across countries as well as groups of countries. Whilst most countries require banks to classify a loan as nonperforming if payments are in arrears, almost 35% of the countries in our sample allow the recognition of nonperforming loans based on a forward-looking estimate of the PD. This finding is by far more pronounced in highly developed countries. Our findings can have important implications for the analysis of loan loss provisions in cross-country settings.

What Drives Heterogeneity of Procyclicality of Loan Loss Provisions in the EU?

What Drives Heterogeneity of Procyclicality of Loan Loss Provisions in the EU?

Income Smoothing and Procyclicality of Loan Loss Provisions in Central European Banks

This paper analyses income smoothing and procyclicality of loan loss provisions in Central European banks under changing macroeconomic conditions. We find strong empirical evidence for income smoothing, which displays a discretionary character and may relate to a non-prudential motivation of managers. We do not find any evidence for “saving for a rainy day” hypothesis in the 2004-2012 period. Conversely, we document strong procyclicality of provisions in relation to economic growth. Banks in Central Europe do not take advantage of macroeconomic upheavals to build sufficient reserve cushions and may have to use capital to cover credit losses during economic downturns. In addition, banks decrease provisions at times of strong loan growth, proving a lack of forward-looking perspective in credit policies. As a result, there is scope for introducing dynamic provisioning regulations in Central European banking systems, which would have to be paired however with regulations minimising managerial private benefit seeking.