There are two fundamental approaches to loan loss provisioning: a negative approach and a discretionary approach. Negative provisioning is the most traditional approach, whereas a non-discretionary approach is the most modern approach. Both approaches have benefits and drawbacks, but whichever one you choose, it is important to understand the risks and rewards of each method. The following discussion will address some of the important topics surrounding loan loss provisioning.
The term negative provisioning in loan loss provision is used to describe a situation where a bank’s allowance estimate at the end of a quarter is less than the actual allowance per the general ledger. For example, if a bank’s ALLL balance was $150,000 at the end of November and only $125,000 at the end of December, negative provisioning would be $25,000 on the bank’s books. Negative provisioning is not new. In the economic expansion of 2004-2007, many institutions recorded negative provisioning. Some community banks have begun recording it since 2007.
Despite the negative impact of negative provisions, banks continued to set aside capital to meet their liquidity needs. Although the provisioning trend was generally negative in the third quarter, some banks reported lower quarterly provisions. At the time of writing, seventy-three of the seven largest international banks had published their third quarter financial data. Of these, six of them had made announcements of negative provisioning. This means that banks are reducing their loan loss reserves.
The study shows that a non-discretionary approach to loan loss provisions is counter-cyclical and may constrain banks during a recession. Moreover, non-discretionary provisions are associated with a reduction in the incentive of banks to provide new credit. To understand the effect of non-discretionary approaches to loan loss provisions, it is important to examine the financial conditions of Italian banks.
To assess the effectiveness of discretionary loan loss provisions, the authors used a conditional valuation method. In this method, they use three continuous variables that reflect the general business cycle movements. They include the percentage growth rate of real GDP, the cross-sectional median Tobin’s Q, and the Consumer Sentiment Index. In addition, they used dummy variables (years) to control for the stock returns over the year.
The Basel Committee has a specific mandate for a non-discretionary approach to loan loss provisions. In August 2009, the Basel Committee issued a set of high-level guiding principles on loan loss provisioning. In the report, the Basel Committee argues that a backward-looking provisioning approach is more pro-cyclical in both developed and emerging countries. In emerging countries, the business cycle is highly amplitude, and capital buffers may not be sufficient to dampen cyclicality.
Impact of capital markets on provisioning
In developing countries, backward-looking provisioning practices may exacerbate procyclicality and increase bank lending. Emerging economies exhibit strong amplitudes of business cycles and, thus, countercyclical tools based on capital buffers might not be sufficient to dampen cyclicality. In such contexts, implementation of a forward-looking provisioning system should be a priority. But if capital buffers alone are insufficient, countries should also consider the impact of changing their accounting standards and adopting a dynamic provisioning regime.
The effects of capital markets on loan loss provisioning are largely positive. A positive relationship between the two measures of non-performing loans and bank capital is a sign of improved earnings for clients and investors. This relationship is not significant, however. The results of the study are not applicable to all emerging countries. This is because the ratio of non-performing loans and total assets to bank capital varies significantly in these countries.
Impact on banks’ ability to provide services
As the economy continues to face challenges, sudden identification of problem loans constrains banks’ ability to provide new credit. As a result, non-discretionary loan loss provisioning must be considered. Ultimately, this deters banks from providing new credit. However, prudential regulation should not relax rules and encourage banks to hide losses. Instead, supervisors should provide comprehensive guidance on prudential loan loss provisioning and ensure that supervisors are monitoring assets.
The negative relationship between loan loss provisions and regulatory capital is a consequence of the risk profile of a bank. A bank with higher levels of risk tends to record more loan loss provisions and less regulatory capital. In the EU, the minimum loan loss provision ratio depends on the number of years exposure has been classified and the security level. Other countries link provisioning requirements with past-days. Some countries also use additional provisioning to adjust their regulatory capital ratio.