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13 th Conference of the ECB-CFS Research Network Session 4 Comments. Pierre-Richard Agénor. University of Manchester. Context and Background. 3. 4. Bank capital should cover for unexpected credit losses, whereas loan loss provisions (LLPs) are intended to cover expected credit losses.
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13th Conference of the ECB-CFS Research Network Session 4 Comments Pierre-Richard Agénor University of Manchester
Bank capital should cover for unexpected credit losses, whereas loan loss provisions (LLPs) are intended to cover expected credit losses. In practice, LLPs cover incurred losses, entirely based on historical information. Do not incorporate information from expected future changes in variables that affect credit defaults. If expected losses > incurred losses: regulatory capital ratios overstate bank capital available to protect against insolvency risk.
Accounting rules governing LLPs are also procyclical. Banks tend to increase LLPs during a downturn (recognition of pending losses). Well documented in cross-country data (Bouvatier and Lepetit).
Inverse relation with earnings. Reduces ability to raise capital through internal means. As with bank regulatory capital, concern is that if banks must rapidly raise reserves during bad times, the bad times could get prolonged.
9 Source: Balla and McKenna (2009).
Limited attention has been given to the role that dynamic LLPs can play to mitigate the procyclical features of accounting rules. Several countries already use them. By making provisions in good times, banks will avoid using capital in a downturn (when it is more expensive)… …thereby reducing the probability of failure from capital deficiencies.
Other issue: role of monetary policy, and interactions between macroprudential regulation and monetary policy. Few papers (so far) study jointly “augmented” monetary policy rules and countercyclical regulatory rules. Key question: are these policies complementary or substitutes?
US GAAP accounting rules: allowance for loan losses are calculated based on current economic conditions. Need to account for forward-looking measures. Main conclusion: effectiveness of a DLLP depends on the severity of a downturn. Reserve buffer created in good times may not suffice to withstand a downturn if it is more severe than observed during the average historical cycle.
But this is by definition; DLLP objective is to help to mitigate downturns (cover expected losses). Was DLLP system key in explaining differences in performance between US and Spanish banks? Alternative formulas? Main limitation: ignores the endogenous response of bank behavior to regulatory changes. Lucas Critique; a change in LLP methodology is likely to influence bank behavior.
Not only restrain credit supply during expansions (due to additional provisions)… …but also capital buffers, with a precautionary motive (Repullo and Suarez (2009)). Banks may hold capital buffers today to mitigate possibility that lending ability is compromised in the future by adverse shocks. Inverse relation between LLPs and buffers in good times.
If buffers have a signaling effect, this could increase the cost of raising capital in bad times… …and thus the cost of credit, which would be procyclical. Provisioning may be lower when asset prices are rising and reflected in collateral valuations. Davis and Zhu (2005): provisions are lower when commercial property prices are rising.
Provisioning may thus amplify credit cycles through the collateral channel. Lending and other variables would take on values different from those actually observed and used in the simulations.
Should DLLP systems be designed to cover the most extreme events… …and eliminate entirely risks associated with the most extreme shocks? What are the trade-offs? Financial stability vs. efficiency/welfare. Optimal setting of DLLP: hard to address in a partial equilibrium setting.
Model-based definition of financial stability? “Weak” form: volatility of some price/quantity. “Strong” form, in a bank-only world: risk of banking collapse. Key contribution. Tractable analytical definition, in line with some other recent work (Goodhart et al., Zhou). Other contribution: optimal combinations of macro- prudential regulation and monetary policy.
Two alternative forms of “leaning against the wind” examined: a positive response of the policy interest rate to asset prices or to bank leverage. Minor technical issues. Improve specification of Basel II regime (advanced IRB instead of standardized IRB)… …as well as the Basel III regime (direct link with credit growth).
Central bank has no explicit financial stability objective. Volatility of the probability of bank run? Plausible but arbitrary values of parameters of financial variables in the interest rate rule; need to be determined optimally… …with or without constraints on other parameters of the Taylor rule. Determine optimally b1c also.
Provisions and capital may well play a complementary role as buffers for expected and unexpected losses… …by minimizing the amplification mechanism induced by regulation and accounting. Introduce both DLLP system and countercyclical capital regulation in DSGE model. Performance of other macroprudential tools.
