PROCYCLICAL BEHAVIOR OF LOAN LOSS PROVISIONS AND BANKING STRATEGIES: AN APPLICATION TO THE EUROPEAN BANKS

Didelle Dilou Dinamona
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Didelle Dilou Dinamona: Centre de Recherche en Sciences Economiques de l'université de Saint-Étienne, 6 Rue Basse des Rives, 42023 Saint-Etienne cedex 02, France

Chapter 9 in Risk Management and Value:Valuation and Asset Pricing, 2008, pp 177-203 from World Scientific Publishing Co. Pte. Ltd.

Abstract: AbstractMany authors emphasize the procyclicity of the capital ratio to explain financial instability. The extent of the debates leads us to question on the procyclicity of loan loss provisions (LLP). Few works were interested in the procyclical character of the policy of provisioning. However, the accounting practices as regards provisioning of the loans losses adopted by the banks can reinforce financial instability.The objective of this contribution is to study the determinants of the pro-cyclical behavior of loan loss provisions in response to the interrogations caused by the new regulation of Basel II. We analyze the procyclical behavior of the universal banks in the constitution of loan loss provisions. An empirical model on panel data is then adopted by the European banks of 1992–2004. The results are in conformity with those obtained in the former literature to know that the banks adopt procyclical behavior as regards provisioning. We show that when we separately consider the banks according to their degree of diversification (of the activities) the results which we obtain are different. These results enable us to have interesting conclusions like the taking into account the risk weighted asset reduces the volatility of loan loss provisions during the cycle much more for diversified banks than for specialized banks. The findings of our research are consistent with the empirical work of Laeven and Majnoni (2003), and of Bikker and Metzemakers (2005) who show that the banks fund more the loans losses in economic downswings than in economic upswings for a whole of the OECD countries.

Keywords: Risk; Value; Management; Derivatives (search for similar items in EconPapers)
Date: 2008
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