The procyclicality of loan loss provisions in Islamic banks

Abstract

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.

Bank income smoothing, institutions and corruption

“…At country level, real gross domestic product growth (ΔGDP) captures bank provisioning that depend on the state of the economic cycle. The literature document that bank provisioning increases significantly during economic downturns and decreases during good years (Leaven and Majnoni, 2003;Bikker and Metzemakers, 2005;Agénor and Zilberman, 2015;Soedarmono et al, 2017). Therefore, a negative sign for the ΔGDP coefficient is expected.…”

Nonperforming loans in the GCC banking sectors: Does the Islamic finance matter?

“…The final and recent trends in the literature that are related to NPL seem to concentre on investigating the determinants of NPL within banking sector in the form of macroeconomic and microeconomic factors (Salas and Saurina, 2002;Lu et al, 2005;Espinoza and Prasad, 2010;Louzis et al, 2012). Furthermore, some recent studies have investigated the relationship between NPL or loan loss provisioning, macroeconomic factors, and business cycle (Nkusu, 2011;Soedarmono et al, 2016).…”

Bank loan loss provisions research: A review of the empirical literature

“…Procyclicality occurs when banks increase their LLP when economic conditions deteriorate and reduce LLP when the economy improves (Adzis, Tripe, & Dunmore, 2016). The hypothesis related to the negative relationship between GDP and LLP is expressed by Taktak (2011), Soedarmono, Pramono, & Tarazi (2017), and Abu-serdaneh (2018). They show that GDP can reflect the business cycle, the negative relationship between LLP and GDP proves the existence of anti-business cyclical behavior by the bank.…”

“…Islamic banks have implemented the expected loan loss model (E-LLM) in lieu of the loan loss model (I-LLM) (Soedarmono, Pramono, & Tarazi 2017). Several countries participating in AAOIFI (Accounting and Audit Organizations for Islamic Financial Institutions) have implemented E-LLM in 2010 while the implementation of E-LLM is a conventional bank that was postponed until 2018 (Soedarmono, Pramono, & Tarazi 2017). Applications between the two models in the banking industry receive various criticisms.…”

“…The relationship between LLP and economic conditions is also the concern of researchers. research on procyclicality and LLP was conducted by several researchers (Taktak, 2011;Beatty & Liao, 2014;Adzis, Tripe, & Dunmore, 2016;Soedarmono, Pramono & Tarazi, 2017;Abu-serdaneh, 2018). Akins, Dou, & Ng (2017), Marton & Runesson (2017), and Jin et al (2018) examined the relationship of corruption and LLP, incentives and social capital.…”