Good Buffer, Bad Buffer
68 Pages Posted: 16 Dec 2016 Last revised: 27 Feb 2019
Date Written: December 15, 2018
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: Suggested Citation