Journal of Law, Finance, and Accounting > Vol 4 > Issue 2

Good Buffer, Bad Buffer: Smoothing in Banks’ Loan Loss Provisions and the Response to Credit Supply Shocks

Sudarshan Jayaraman, Simon Business School, University of Rochester, USA, jayaraman@simon.rochester.edu Bryce Schonberger, Simon Business School, University of Rochester, USA, bryce.schonberger@simon.rochester.edu Joanna Shuang Wu, Simon Business School, University of Rochester, USA, joanna.wu@simon.rochester.edu
 
Suggested Citation
Sudarshan Jayaraman, Bryce Schonberger and Joanna Shuang Wu (2019), "Good Buffer, Bad Buffer: Smoothing in Banks’ Loan Loss Provisions and the Response to Credit Supply Shocks", Journal of Law, Finance, and Accounting: Vol. 4: No. 2, pp 183-238. http://dx.doi.org/10.1561/108.00000037

Published: 13 Dec 2019
© 2019 S. Jayaraman, B. Schonberger and J. S. Wu
 
Subjects
Corporate finance,  Financial reporting,  Corporate governance,  New business financing: Bank financing, debt, and trade credit,  Regulation
 
Keywords
JEL Codes: G01, G21, M41
SmoothingLoan loss provisioningCrunchCrisisBank lending
 

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In this article:
1. Introduction
2. Related Literature
3. Hypothesis Development
4. Data and Research Design
5. Results
6. Conclusions
Appendix A: Sample of Bank Holding Companies During the Emerging Market Crises Period
Appendix B: Variable Definitions
Appendix C: Estimating Preemptive Loan Loss Provisioning (SMOOTH)
References

Abstract

Bank regulators and academics have long conjectured the beneficial effects of smoothing in loan loss provisions(i.e., making higher provisions during good times so as to avoid doing so during bad times) for bank lending and stability, while accounting regulators express concerns about its potential adverse impact on reporting transparency. 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 via smoothing. These lending differences translate into positive real effects for the buffering banks’ small borrowers. However, consistent with the dark-side, these benefits of smoothing are absent in banks with insider lending, suggesting opportunistic smoothing. Overall, our results highlight the tradeoff between bank stability and transparency inherent in smoothing loan loss provisions– while proactive recognition of unrealized losses reduces bank transparency, it increases bank stability (if and) when losses materialize.

DOI:10.1561/108.00000037