The Procyclicality of Loan Loss Provisions in Islamic Banks

21 Pages Posted: 23 May 2016

See all articles by Wahyoe Soedarmono

Wahyoe Soedarmono

Sampoerna University - Faculty of Business

Sigid Eko Pramono

Bank Indonesia

Amine Tarazi

University of Limoges - Faculty of Law and Economic Science

Date Written: May 21, 2016

Abstract

From a sample of Islamic banks around the world from 1997 to 2012, this paper examines whether loan loss provisioning in Islamic banks is procyclical. Our empirical findings highlight that loan loss provisioning in Islamic banks remains procyclical, although the ‘expected’ loan loss model (E-LLM) has been implemented for Islamic banks in several countries. A closer investigation further documents that Islamic banks also use loan loss provisions for discretionary managerial actions, especially related to capital management in which loan loss reserves and provisions are inflated when bank capitalization declines. Eventually, this paper highlights that higher capitalization can mitigate the procyclicality of loan loss provisions in Islamic banks. In other words, loan loss provisioning becomes countercyclical for Islamic banks with higher capitalization. This paper therefore casts doubts on the adoption of the E-LLM for Islamic banks to promote countercyclical effects, because the E-LLM may be influenced by managerial discretion, including opportunistic capital management using loan loss provisions that may undermine the importance of maintaining sufficient bank capitalization.

Keywords: Islamic banks, loan loss provisions, capital management, procyclicality

JEL Classification: G15, G21, G28, M41

Suggested Citation

Soedarmono, Wahyoe and Pramono, Sigid Eko and Tarazi, Amine, The Procyclicality of Loan Loss Provisions in Islamic Banks (May 21, 2016). Available at SSRN: https://ssrn.com/abstract=2782730 or http://dx.doi.org/10.2139/ssrn.2782730

Wahyoe Soedarmono (Contact Author)

Sampoerna University - Faculty of Business ( email )

Jl. Raya Pasar Minggu, Kav. 16
Jakarta, Pancoran 12780
Indonesia

Sigid Eko Pramono

Bank Indonesia ( email )

JL. M.H. Thamrin No. 2
Jakarta, 10350
Indonesia

Amine Tarazi

University of Limoges - Faculty of Law and Economic Science ( email )

5 rue Felix Eboue
Limoges, 87000
France

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