Regulatory Capital Ratios, Loan Loss Provisioning and Pro-Cyclicality

Abstract:     
Banks with low regulatory capital facing external-financing frictions may reduce lending to avoid a capital shortage. The capital crunch theory predicts that banks’ lending is particularly sensitive to their capital ratios during recessions. Procyclicality in bank lending may be magnified when banks’ loan loss provisioning is backward looking given the increase in loan defaults that occur during recessions. We find that, relative to more conservative banks, banks with less conservative loan loss provisions reduce their lending more during recessionary relative to expansionary periods. We also find that conservatism in loan loss provisioning reduces the capital crunch effect during recessionary periods.

Number of Pages in PDF File: 36

Keywords: bank lending, loan loss provision, procyclicality, recession, accounting conservatism

JEL Classification: M41, E32

working papers series