Expected Loan Loss Provisioning: An Empirical Model
49 Pages Posted: 1 Mar 2019 Last revised: 7 Mar 2019
Date Written: February 28, 2019
Recently introduced accounting standards require that financial institutions provision for expected losses on their loan portfolios. Understanding the economic consequences of provisioning for expected losses is of significant interest to academics and regulators. We develop an empirical model of expected loan loss provisioning and use it to construct a bank-year measure of under-provisioning for expected losses. The model relies on forward-looking bank- and macro-economic indicators of future losses. The estimated expected losses are substantially more informative in explaining realized losses as compared to the reported numbers. Unlike the reported provisions, the estimated provisions for expected losses behave in a counter-cyclical fashion. Using our measure of under-provisioning, we find evidence consistent with under-provisioning for expected losses distorting banks’ lending, financing, and dividend decisions. While in practice banks need not provision in the way predicted by the model, we provide a useful benchmark to evaluate provisioning under the new accounting rules.
Keywords: expected loss model, loan loss provisioning, under-provisioning, bank decisions
JEL Classification: G21, M40, M41
Suggested Citation: Suggested Citation