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

The recent debate on the pro-cyclical effects of capital regulation has so far overlooked the important role that bank loan loss provisions and reserves play in the overall minimum capital regulatory framework. This paper suggests that recent advances in the techniques for assessing borrowers creditworthiness make it possible to extend risk-based regulation to loan loss reserves—coherently with the approach taken for bank minimum capital requirements—with beneficial cyclical effects. Notwithstanding its analytically viability a risk-based regulation of bank loan loss provisions may not be easy to implement due to the presence of relevant agency problems between bank stakeholders. We find empirical support for our hypotheses over a sample of 1,176 large commercial banks, 372 of which from non-G10 countries, over the period 1988–1999. After controlling for different country specific macroeconomic and institutional features, we find robust evidence of a differentiated cyclical pattern among G10 and non-G10 countries. While, on average, banks located in G10 countries showed a positive relation between operating income and provisions, the reverse appeared to hold for non-G10 banks.