Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Dynamic Provisioning: A Countercyclical Tool for Loan Loss Reserves

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Dynamic Provisioning: A Countercyclical Tool for Loan Loss Reserves

Article excerpt

(ProQuest: ... denotes formula omitted.)

The methodology to recognize loan losses set forth by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) is referred to as the incurred loss model and defined as the identification of inherent losses in a loan or portfolio of loans. Inherent credit losses, under current accounting standards in countries following FASB and IASB, are event driven and should only be recognized upon an event's occurrence.1 This has tended to mean that reserves for loan losses on a bank's balance sheet need to grow significantly during an economic downturn, a time associated with increased credit impairment and default events. Critics of the incurred loss model have pointed to it as one of the causes of the severity of strain many financial institutions experienced at the onset of the financial crisis of 2007-2009. As rapid provisioning to increase loan loss reserves made headlines, discussions of international regulatory banking reform included the method of dynamic provisioning as a potential alternative to the incurred loss approach (see, for example, Cohen 2009). Dynamic provisioning is a statistical method for loan loss provisioning that relies on historical data for various asset classes to determine the level of provisioning that should occur on a quarterly basis in addition to any provisions that are event driven.2 The primary goal of dynamic provisioning is the incremental building of reserves during good economic times to be used to absorb losses experienced during economic downturns.

We begin this paper with a discussion of the current approach to loan loss reserves (LLR) in the United States. We argue that, to a social planner who cares both about avoiding bank failures and the efficiency of bank lending, the current accounting and regulatory approach for LLR may be suboptimal on both fronts. First, by taking provisions after the economic downturn has set in, a bank faces higher insolvency risk. When a banker or regulator determines that a bank has inadequate LLR, the bank will have to build the reserves in an unfavorable economic environment. Also, inadequate reserves imply that regulatory capital ratios have been overstated, placing the bank at a higher risk for resolution by the Federal Deposit Insurance Corporation (FDIC). Second, as most banks tend to increase LLR during the economic downturn, the current approach may be procyclical; that is, it may amplify the business cycle. We aim to highlight some of the potential inefficiencies under the incurred loss approach by contrasting it to dynamic provisioning. Dynamic provisioning was instituted in Spain in 2000 in response to some of the same problems we highlight in the United States. We present a conceptual framework to compare loan loss provisioning under the incurred loss framework and dynamic provisioning. Then we simulate dynamic provisioning with U.S. data to present an empirical comparison. In the remainder of this section, we offer a brief summary of our main arguments and the conclusions from the simulation exercise.

In accounting terms, the LLR account, also known as the allowance for loan and lease losses (ALLL), is a contra-asset account used to reduce the value of total loans and leases on a bank's balance sheet by the amount of losses that bank managers anticipate in the most likely future state of the world.3 LLR incorporate both statistical estimates and subjective assessments. Provisioning is the act of building the LLR account through a provision expense item on the income statement. While we present the intuition behind LLR in this section, the Appendix to the paper describes their important accounting features in basic terms.

Interest margin income from loans is a smooth flow whereas a loan default or impairment event causes a lumpy drop in the stock of bank assets. This introduces volatility to banks' balance sheets. By themselves, a large number of loans may be insufficient to smooth these fluctuations out due to the correlation between the risks in the portfolio of bank loans. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.