Loan-loss provisioning policy is critical in assessing financial system stability, in that it is a key contributor to fluctuations in banks’ profitability and capital positions, which has a bearing on banks’ supply of credit to the economy (Beatty and Liao, 2009). In principle, loan-loss provisions allow banks to recognize in their profit and loss statements the estimated loss from a particular loan portfolio/s, even before the actual loss can be determined with accuracy and certainty as events unfold and is actually written off. In other words, loan-loss reserves should result in direct charges against earnings during upturns in the economic cycle, as banks anticipate future losses on the loan portfolio when the economy hits a downturn. When these anticipated loan losses eventually crystallize, banks can then draw on these reserves, thereby absorbing the losses without impairing precious capital and preserving banks’ capacity to continue extending the supply of credit to the economy. Ideally, the level of loan loss provisioning, should be able to reflect the beliefs of bank management on the quality of the loan portfolio that they have, indicating that provisions should be able to cover the whole spectrum of expected credit losses if they are to think of provisions as a measure of true credit risk (Dugan, 2009).
In practice, the level of provisioning has had a historically procyclical bias, as it is basically linked to contemporaneous problem assets, so that provisions mainly rise during a downturn (see Borio and Lowe, 2001; Bikker and Hu, 2002; Laeven and Majnoni, 2003), when credit risk has already materialized. There are some factors that contribute to its procyclicality: for one, business cycle developments are hard to identify, and therefore there may exist a disconnect between the timing of loan-loss provisioning and the assessment of credit risk. For another, accounting frameworks only allow provisioning for losses that have already been incurred as of a financial statement date, which does not really address the concept of “expected losses” (Li, 2009). Moreover, a surplus of funds relative to the appropriate level of prudent loans being granted could lead to the chasing of yields and the lowering of credit risk perception, and hence, corresponding provisions. If provisions are not able to cover the whole spectrum of potential loan defaults once an economic downturn occurs, then, naturally, the bank will need to cover the excess loss from its capital. As the recent global credit crisis have shown, the impact of an increase in loan defaults on financial system fragility also depended on whether banks build capital cushions to absorb unexpected loan losses not covered by provision levels.
The relationship between loan-loss provisions and capital—two of the most vital macroprudential policy tools by which supervisory authorities use to ensure banking stability—is linked by the BASEL II framework, the developments of which have lead to the use of loan loss provisions to cover expected losses, and capital to cover unexpected losses (BCBS, April 2009).
The modification in the capital requirement regulation (Basel II) is a structural change that has several important policy implications. For one, the regulation stresses the importance of building up and maintaining the necessary capital given the specific risk profile of each bank. This suggests that different capital positions may have a bearing in the way banks react to an increase in risk—for given economic conditions—and hence in provisions. Second, the capital allocation feature of loan-loss provisions in the Basel II framework may provide incentives for banks to increase provisions to meet capital requirements. In particular, banks with low capital levels may increase loan-loss provision levels in order to comply with the regulatory requirement and to mitigate solvency risk. Therefore, banks’ capital adequacy ratios could have an important effect on banks’ decisions in setting the optimal level of loan loss provisions (Beattie et al.1995).
In any case, it is then clearly of interest to investigate on the determinants of loan-loss provision decisions by banks, particularly the role of capital buffers in banks’ provisioning decisions in the light of capital regulatory requirements to better understand the endogenous behavior of financial institutions and the dynamics of the relationship between provisions and macroeconomic variables in the Philippine case. As Laeven and Majnoni (2003) point out, the regulation of bank capital and loan loss reserves has to consider the incentives of banks to take into account macroeconomic shocks, together with the idiosyncratic ones in their loan loss provision decisions, especially for the stability of emerging market banking systems.
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Loan Loss Provisioning and the Business Cycle: Does Capital Matter? Evidence from Philippine Banks
