Good Buffer, Bad Buffer

69 Pages Posted: 16 Dec 2016 Last revised: 14 Jul 2017

See all articles by Sudarshan Jayaraman

Sudarshan Jayaraman

University of Rochester - Simon Business School

Bryce Schonberger

University of Rochester - Simon Business School

Joanna S. Wu

University of Rochester - Simon Business School

Date Written: March 7, 2017

Abstract

Bank regulators and academics have long conjectured the beneficial effects of preemptive loan loss provisioning (i.e., making higher provisions during good times so as to avoid doing so during bad times) for bank lending and stability. In contrast, accounting regulators express concerns about its potential adverse impact on reporting transparency due to the ensuing income smoothing. 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 by provisioning preemptively. These lending differences translate into positive real effects for the buffering banks’ small borrowers. However, consistent with the dark-side, these benefits of preemptive provisioning are absent in banks with insider lending, suggesting opportunistic smoothing. Our inferences are robust to addressing the endogeneity of preemptive loan loss provisioning and to corroborating the emerging market evidence with large-sample tests using Federal Reserve data on lending supply and demand. Overall, our results highlight the tradeoff between bank stability and transparency inherent in preemptive provisioning – while proactive recognition of unrealized losses reduces bank transparency, it increases bank stability (if and) when losses materialize.

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

JEL Classification: G01, G21, M41

Suggested Citation

Jayaraman, Sudarshan and Schonberger, Bryce and Wu, Joanna, Good Buffer, Bad Buffer (March 7, 2017). Simon Business School Working Paper No. FR 17-03; 28th Annual Conference on Financial Economics and Accounting. 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 Rochester - Simon Business School ( email )

Rochester, NY 14627
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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