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

Journal of Law, Finance, and Accounting, Forthcoming

61 Pages Posted: 16 Dec 2016 Last revised: 25 Feb 2020

See all articles by Sudarshan Jayaraman

Sudarshan Jayaraman

University of Rochester - Simon Business School

Bryce Schonberger

University of Colorado at Boulder - Leeds School of Business

Joanna S. Wu

University of Rochester - Simon Business School

Date Written: August 15, 2019

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

Suggested Citation

Jayaraman, Sudarshan and Schonberger, Bryce and Wu, Joanna, Good Buffer, Bad Buffer: Smoothing in Banks' Loan Loss Provisions and the Response to Credit Supply Shocks (August 15, 2019). Journal of Law, Finance, and Accounting, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2886181 or http://dx.doi.org/10.2139/ssrn.2886181

Sudarshan Jayaraman (Contact Author)

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States

Bryce Schonberger

University of Colorado at Boulder - Leeds School of Business ( email )

Boulder, CO 80309-0419
United States

Joanna Wu

University of Rochester - Simon Business School ( email )

Carol Simon Hall 3-160D
Rochester, NY 14627
United States
585-275-5468 (Phone)
585-442-6323 (Fax)

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