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What Drives Heterogeneity of Cyclicality of Loan-Loss Provisions in the EU?

Journal of Financial Services Research volume 51, pages 55–96 (2017)Cite this article

Abstract

In the theory of banking, prudent risk management is perceived as being necessary to curb the excessive procyclicality evident in many activities of banks. As banks differ in their risk-management approaches, their sensitivity to the business cycle is also far from uniform. This paper aims to identify the sources of such diverse relationships between loan-loss provisions (LLP) and the business cycle. Using the two-step system GMM Blundell and Bond estimator on a panel database of over 3000 banks operating in the European Union (EU) in 1996–2011, this study documents a large cross-bank and cross-country variation in the relationship between loan-loss provisions and the business cycle and explores bank-management specific, bank-activity specific and country-specific features that explain this diversity in the EU. Our results indicate that LLP in large, publicly-traded and commercial banks, as well as in banks reporting consolidated statements, are more procyclical. More restrictive capital standards and better investor protection are linked with weakened procyclicality of LLP. Neither official supervision nor private-market monitoring is effective in reducing the procyclicality of LLP. Thus, our study supports the view that microprudential supervision is not sufficient to combat the procyclicality of the banking sector, and therefore should be supplemented with macroprudential supervision. Moreover, as large banks LLP are definitely more procyclical, we provide empirical support for the post-crisis restrictive regulations (Basel III and macroprudential policy) of systemically-important financial institutions (SIFIs). This study also lends empirical support to the hypothesis that more income smoothing and greater coverage of expected loan losses reduce the procyclicality of LLP.

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Acknowledgments

We gratefully acknowledge the financial support provided by the Polish National Science Centre (NCN), decision number DEC-2012/05/D/HS4/01356. This paper’s findings, interpretations, and conclusions are entirely those of the authors and do not necessarily represent the views of the University of Warsaw or other institutions to which the authors are affiliated. We thank participants in the “Panel Data Modeling Conference. Theory and practice 2014” held at the Warsaw School of Economics, in the scientific seminar held in 2014 at National Bank of Poland and in the International Conference on Management, Banking and Finance at the University of Warsaw, for their helpful comments and suggestions. We also thank an anonymous referee for fruitful comments and suggestions which enhanced the quality of this paper.

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Authors and Affiliations

  1. Department of Banking and Money Markets, Faculty of Management, University of Warsaw, ul. Szturmowa 1/3, 02-678, Warsaw, Poland

    Małgorzata Olszak

  2. Department of Econometrics and Operations Research, Faculty of Management, Cracow University of Economics, Cracow, Poland

    Mateusz Pipień

  3. Department of Mathematical and Statistical Methods, Faculty of Management, University of Warsaw, Warsaw, Poland

    Iwona Kowalska

  4. Chair of Macroeconomics, Faculty of Economics and Social Sciences, University of Łódź, Łódź, Poland

    Sylwia Roszkowska

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  1. Małgorzata Olszak
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  2. Mateusz Pipień
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  3. Iwona Kowalska
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Correspondence to Małgorzata Olszak.

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Olszak, M., Pipień, M., Kowalska, I. et al. What Drives Heterogeneity of Cyclicality of Loan-Loss Provisions in the EU?. J Financ Serv Res 51, 55–96 (2017). https://doi.org/10.1007/s10693-015-0238-6

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  • DOI: https://doi.org/10.1007/s10693-015-0238-6

Keywords

  • Loan-loss provisions
  • Procyclicality
  • Income smoothing
  • Investor protection
  • Bank regulation
  • Bank supervision

JEL Classification

  • E32
  • G21
  • G28
  • G32