Good Buffer, Bad Buffer: Smoothing in Banks’ Loan Loss Provisions and the Response to Credit Supply Shocks

Sudarshan Jayaraman, Bryce Schonberger and Joanna Shuang Wu

Journal of Law, Finance, and Accounting, 2019, vol. 4, issue 2, 183-238

Abstract: Bank regulators and academics have long conjectured the beneficial effects of smoothing in loan loss provisions(i.e., making higher provisions during good times so as to avoid doing so during bad times) for bank lending and stability, while accounting regulators express concerns about its potential adverse impact on reporting transparency. Using the late 1990s emerging market crisis to capture an adverse supply shock to bank capital, we show, consistent with the bright-side, that ensuing contractions in bank lending are weaker for banks that built buffers via smoothing. These lending differences translate into positive real effects for the buffering banks’ small borrowers. However, consistent with the dark-side, these benefits of smoothing are absent in banks with insider lending, suggesting opportunistic smoothing. Overall, our results highlight the tradeoff between bank stability and transparency inherent in smoothing loan loss provisions– while proactive recognition of unrealized losses reduces bank transparency, it increases bank stability (if and) when losses materialize.

Keywords: Corporate governance; Corporate finance; Financial reporting; New business financing: Bank financing; debt; and trade credit; RegulationSmoothing; Loan loss provisioning; Crunch; Crisis; Bank lending (search for similar items in EconPapers)
JEL-codes: G01 G21 M41 (search for similar items in EconPapers)
Date: 2019
References: Add references at CitEc
Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:now:jnllfa:108.00000037

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