Dynamic Provisioning: Rationale, Functioning, and Prudential Treatment

Abstract

Current policy debate has renewed interest in counter-cyclical provisioning policies; dynamic provisions are regarded as a valuable device for pursuing this goal. Last July, Ecofin supported "the introduction of forward-looking provisioning, which consists in constituting provisions deducted from profits in good times for expected losses on loan portfolios, and which would contribute to limiting procyclicality". This paper describes: i) How dynamic provisions work in a general framework based on expected losses; ii) How they work according to the Spanish system, which is the only real example of countercyclical provisioning; iii) The differences and similarities between the expected loss model and the Spanish approach. Building on proposals currently under discussion in the international community, it also suggests a possible way forward for introducing a system of dynamic provisions that, while meeting the prudential goal of having more conservative provisioning policies, would not clash with accounting standards.

Keywords: dynamic provisions, capital buffers, Basel 2, credit risk, procyclicality

JEL Classification: G21, G28