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.
This paper studies the sectoral decomposition of the volatility of real exchange rates. The real exchange rate between two countries is the relative price of a representative goods basket. The sectoral decomposition of real exchange rate fluctuations is important, because it has important implications for the dynamic adjustment of an open economy to exogenous shocks. For some countries, the movements in relative price levels come from the relative prices of internationally nontraded goods such as housing or construction, while for others from those of traded goods such as manufactures. The empirical part in the next section finds that, while in general the relative prices of traded goods are the most important in driving real exchange rate movements, the relative prices of nontraded goods are relatively more important for the country pairs that maintain stable nominal exchange rates.
It is a widely accepted result that executives usually value stock options at lower than market values. Hall and Murphy (2002) argue that executives are undiversified and risk averse, so they value their stock options at lower than market values. In addition, they also argue that stock options are inefficient relative to restricted stock because of the lower sensitivity of option values to the change in stock prices. Moreover, Meulbroek (2001) argues that executives bear more than the optimal level of firm-specific risk and, therefore, require a higher risk premium.
These arguments have some explanatory power for low executive option values, and these factors affect substantially the incentives of stock options. Hall (2003), however, mentions that one of the striking features of executive pay during the previous two decades is the remarkable increase in the use of stock options. As shown in Figure 1, the percentage of stock options in median executive compensation increased dramatically from 1992 to 2000. After 2000, options still account for more than 40% of executive pay. Accordingly, one interesting question is why most companies still use stock options to compensate their executives if stock options have low option values and are as inefficient as argued in the literature. We propose one possible answer that managerial ability, which reflects both managerial effort and quality, increases the attractiveness of stock options to managers.
