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

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: smoothing, loan loss provisioning, capital crunch, crisis, bank lending

JEL Classification: G01, G21, M41