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

Abstract

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.

Procyclicality of the Financial Systems in Emerging Economies

“…Furthermore, Olszak and Kowalska (2022) examined the role of competition in the procyclicality of LLPs. They discovered that increased competition was associated with a higher degree of procyclicality in LLPs, particularly in high-income countries.…”

“…Loan-loss provisions refer to the funds set aside by banks to cover potential losses from loans that may default. LLPs are relatively large accruals on bank income statements of banks, therefore, have a significant impact on banks' earnings and regulatory capital (Olszak & Kowalska, 2022). Their levels depend on the expected loan losses and the substantial scope of discretion that bank managers have in choosing the size of LLPs estimates (Olszak & Kowalska, 2022).…”

“…LLPs are relatively large accruals on bank income statements of banks, therefore, have a significant impact on banks' earnings and regulatory capital (Olszak & Kowalska, 2022). Their levels depend on the expected loan losses and the substantial scope of discretion that bank managers have in choosing the size of LLPs estimates (Olszak & Kowalska, 2022). The loan loss provision account, a key component of bank financial statements, directly impacts the net loans reported on the balance sheet, making it a crucial element tied to the primary operating activity of lending and borrowing (Abu-Serdaneh, 2018).…”