Do Banks Provision for Bad Loans in Good Times? Empirical Evidence and Policy Implications

Abstract

Recent debate about the pro-cyclical effects of bankCavallo and Majnoni test their hypotheses with a capital requirements has ignored the important role that sample of 1,176 large commercial banks-372 of them bank loan loss provisions play in the overall framework in non-GlO countries-for the period 1988-99. After of minimum capital regulation.controlling for different country-specific macroeconomic It is frequently observed that underprovisioning, due to and institutional features, they find robust evidence inadequate assessment of expected credit losses, aggravates among G10 banks of a positive association between loan the negative effect of minimum capital requirements loss provisions and banks' pre-provision income. Such during recessions because capital must absorb both evidence is not confirmed for non-GlO banks, which on expected and unexpected losses. Moreover, when expected average provision too little in good times and are forced losses are properly reflected in lending rates but not in to increase provisions in bad times. provisioning practices, fluctuations in bank earningsThe econometric evidence shows that the protection of magnify true oscillations in bank profitability.outsiders' claims-the claims of minority shareholders in The relative agency problems faced by different common law countries and of fiscal authorities in stakeholders may help explain the prevailing and often countries with high public debt-on bank income has unsatisfactory institutional arrangements.negative effects on the level of bank provisions.This paper-a product of the Financial Sector Strategy and Policy Department-is part of a larger effort in the department to study the impact of financial regulation on economic development. Copies of the paper are available free from the World Bank,

NPLs — The Solution Recipe for Albania

“…According to Shehu and Kaci (2014) this strategy increases the credibility of good banks, and reduces the liquidity risk, which is the main cause of banking failure. Cavallo and Majnoni (2002) further find supportive empirical evidence and suggest policy implications regarding banking restructuring. This strategy should be accompanied with a private placed Guarantee Fund, which should monitor and control the process.…”

A Survey of Cyclical Effects in Credit Risk Measurement Models

“…Lown and Morgan (2001) show that fluctuations in commercial credit standards at banks lead to fluctuations in both may not be applicable in countries such as Japan in which the banking system has been unable to efficiently perform the capital allocation process. Cavallo and Majnoni (2001) and Borio, Furfine and Lowe (2001) also model potential counter cyclical effects. They argue that if loan loss reserves are set to equal expected losses, in a forward-looking predictive manner, rather than equal to ex post realized losses, then the procyclical tendencies of banking can be mitigated somewhat.…”

Banking Consolidation in Nigeria, 2000–2010

“…Multi-country analysis usually considers factors such as legal tradition, accounting conventions, regulatory structures, property rights, culture and religion as possible explanations for cross-border variations in financial development and economic growth (Beck, Demirgüc¸-K, and Levine, 2003;Beck and Levine, 2004;La Porta, Lopez-de-Silanes, Shleifer, and Vishny, 1997;Levine, 2003;Stulz and Williamson, 2003). Studies at country level usually focus on market dynamics as determinants of efficiency (Arpa, Giulini, Ittner, and Pauer, 2001;Bikker and Haaf, 2002), or provisions for loan losses which can exert a negative impact on the level of economic activity (Cavallo and Majnoni, 2002;Cavallo and Rossi, 2001;Laeven and Majnoni, 2003). Other factors such as market structure and bank-specific variables have been proposed on the basis of the structureconduct-performance paradigm, and have been used to test the role of ownership and governance in explaining bank performance (see Berger, 1995;Berger and Humphrey, 1997;Bikker and Haaf, 2002;Goddard et al, 2001;Molyneux, Altunbas¸, and Gardener, 1996).…”