Banking Sector Expectations and Financial Stability

Abstract

We analyze banks' expectations embedded in loan loss provisions and document evidence of overreaction for the US banking sector. Using diagnostic-expectations general equilibrium setting, we establish that overreaction in provisions accentuates the procyclicality of lending rate and credit growth. Crucially, our results suggest that for the cyclically-adjusted provisioning rules (IFRS 9/CECL) to have the desired effect on financial stability, the extent of cyclical adjustment may need to be strengthened in proportion to the degree of overreaction in expectations.

Keywords: verreaction, Banks' Expectations, Loan Loss Provisions, Financial Stability

JEL Classification: E44, G21, G41, M41, M48