Do Banks Provision for Bad Loans in Good Times?

Empirical Evidence and Policy Implications

Michele Cavallo* and Giovanni Majnoni **

June 2001

Abstract: The recent debate over the pro-cyclical effects of capital regulation has
overlooked the important role that bank loan loss provisions play in the overall minimum
capital regulatory framework. Inadequate assessment of expected credit losses leads to
under-provisioning and to the shortage of loan loss reserves at times of crisis. As a
consequence, capital has to offset both expected and unexpected losses, aggravating the
negative impact of minimum capital requirements over the economic activity during
recessions. In addition, when expected losses are properly reflected in lending rates but
not in provisioning practices banks earnings fluctuations magnify true bank profitability
oscillations. The often unsatisfactory institutional arrangement for loan loss provisioning
may be seen as an effort to mitigate an agency problems between bank stakeholders
(outsiders versus insiders). We test our hypothesis over a sample of 1176 large
commercial banks, 372 of which from non-G10 countries, over the period 1988-1999.
After controlling for different country specific macroeconomic and institutional features,
we find robust evidence that the relationship between loan loss provisioning and banks’
pre-provision income shows the desirable positive sign for G10 banks. The same sign is,
instead, negative for non-G10 banks, which on average provision too little in good times
and are forced to increase provisions in bad times. We also find that the protection of
“outsiders” claims over banks’ profits has negative effects on loan loss provisioning.

JEL classification numbers: G21, G28.

Keywords: banks, bank regulation, loan loss provisions
*
Michele Cavallo, New York University, Dept. of Economics, 269 Mercer St. New York, NY, 10003. Tel
(212) 998 8972; Fax: (212) 995 4186; email: [email protected]
**
Giovanni Majnoni, corresponding author, The World Bank, 1818 H Street, NW, Washington, DC, 20433.
Tel: (202) 458 7542; Fax: (202) 522 2031; email: [email protected].
1. Introduction1

Pro-cyclical effects of risk-based capital have been a relevant element of concern in

the ongoing debate about new bank capital requirements. The deterioration of banks’
asset quality during cyclical downturns, in fact, requires higher provisions and may drive
capital below minimum requirements exactly when capital is more expensive or simply
unavailable for weaker institutions. When capital shortages are faced by banks
accounting for a large share of total lending to the economy the resulting credit
contraction may have systemic implications 2 .

This paper suggests that cyclical shortages of banks’ capital may not only be due to
the risk based regulation of bank capital but most prominently to the lack of risk based
regulation of bank s’ loan loss provisioning practices. The blame for pro-cyclical effects
associated with capital shortages could therefore shift to some extent from the content of
currently proposed capital regulation to its inadequate comprehensiveness.

The generalized recognition that bank capital should provide a buffer to unexpected
losses is in fact based on the implicit assumption that expected losses have already been
absorbed by properly set loan loss reserves. When, instead, loan loss reserves are
inadequate, expected losses will affect banks’ capital and the impact of capital shortages
on the real economy will be magnified 3 . As a result, for economies where sound
provisioning norms are not embedded in bank practices - as it is the case for most
emerging economies - the lack of a coherent and internationally accepted regulation of
loan loss provisions reduces the usefulness of minimum capital regulation.

1
We would like to thank Franklin Allen, Jerry Caprio, Patrick Honohan, Alain Laurin, Rick Mishkin, Larry
Promisel and Anthony Santomero for useful discussions and Hosook Hwang for outstanding research
assistance. This paper’s findings, interpretations, and conclusions are entirely those of the authors and do
not necessarily represent the views of the World Bank, its Executive Directors, or the countries they
represent.
2
Notwithstanding the widespread concerns, expressed also by the Financial Stability Forum, the Basel
Committee on Banking Supervision (BCBS) has come to the conclusion ”that the proper tool to avoid the
negative macroeconomic effects of risk based capital requirements may not be found in the regulation of
solvency ratios” and that instead “the supervisory review and market discipline pillars of the Accord”
should induce banks to “build up sufficient capital during growth periods” (BCBS, 2000, p.2).
3
The mixed evidence about the effects of new capital requirements on the real economy in G10 countries
has been surveyed in BCBS (1999). Evidence of its significant impact in non-G10 countries is provided by
Chiuri et al (2001).

1
 Notwithstanding its relevance, the regulation of banks’ loan loss provisions has
attracted considerably less attention than that of banks’ minimum capital. We claim that
the difficulty faced by the regulation of banks’ provisioning practices – and therefore its
delayed formulation – lies in the presence of agency problems of difficult solution
between different classes of banks’ stakeholders such as banks’ “outsiders” (minority
shareholders or the fiscal authority) and banks’ “insiders” (bank managers and majority
shareholders).

Lacking a well defined and internationally agreed code of conduct, we face a

multiplicity of institutional solutions. In several cases the protection of “outsiders” claims
to banks’ income may be too rigid or too extensive providing a disincentive to adequate
loan loss provisioning with negative repercussions on the stability of the banking system.

We test empirically our conjectures over a sample of 1176 banks from 36 countries
for the period 1988-1999 and we find that the level of institutional development
significantly affects loan loss provisioning practices. More specifically, we find evidence
that the positive association between loan loss provisioning and banks’ EBTDAs does not
hold for banks located in non-G10 countries. This result is due to inadequate provisioning
in the upswing phase of the cycle which forces these institutions to increase provisions
during periods of financial distress, lending support to our suggestion that a capital
regulation without sound provisioning rules may have pro-cyclical effects. We also find
that a higher level of assertiveness of banks’ “outsiders” – such as the fiscal authority and
minority shareholders - is negatively related to the amount of loan loss provisions,
confirming our conjecture about the incentives structure and the conflict of interests
among different banks’ stakeholders in the definition of provisioning rules. Overall, our
empirical findings suggest that pro-cyclical effects of bank capital regulation can be
reduced, and long run stability of the banking system improved, by a regulatory solution
which strikes a balance between the conflicting objectives of “outsiders” protection and
bank provision enhancement.

The paper is structured as follows. Section 2 draws from the current debate on
banks’ capital requirements, defines different forms of loan loss provisions and discusses
their role. Section 3 illustrates the agency problems raised by the existence of conflicting

2
claims over banks’ income on the part of different stakeholders and the implications on
loan loss provisioning. Section 4 illustrates how different provisioning strategies,
associated with “outsiders” protection, may affect banks’ income smoothing over the
cycle. Section 5 describes the econometric test, the nature of the data used and the results
of the empirical analysis. Section 6 concludes and discusses some policy implications
also with reference to the new proposal for new bank minimum capital requirement of the
BCBS.

2. Provisions and expected losses

Although regulatory capital is intended to provide an adequate buffer against

adverse occurrences to banks’ balance sheets it is not the only relevant buffer bankers can
resort to. The prevailing conceptual framework, summarized in Figure 1, recognizes the
existence of two categories of shock absorbers: loan loss reserves and capital. Regulatory
capital should cope with the occurrence of “unexpected losses”, that is losses that are
large but infrequent and that therefore can be located far in the tail of the frequency
distribution of loan losses. Loan loss reserves should, instead, cope with “expected
losses”, that is losses which occur on average and can be measured by the mean value of
the frequency distribution of loan losses. According to this distinction, the occurrence of
losses equal to OB in Figure 1 should be buffered for the amount OA by loan loss
reserves and for the amount AB by depleting regulatory capital. What Figure 1 makes
clear is that the very effectiveness of regulatory capital as a buffer of unexpected shocks
rests on the existence of the subsidiary buffer represented by the reserves created through
loan loss provisions.

The conceptual distinction between expected and unexpected components of loan

losses carries with it several important implications about the distinctive role and
functions of bank capital and loan loss reserves in the domain of risk management, of risk
measurement and of accounting procedures.

The first immediate consequence is that loan loss provisions cannot be reduced
through portfolio diversification. Differently from capital – which is related to measures
of dispersion and can be reduced through portfolio diversification - provisions for

3
individual loans are related to the mean value of the loss distribution and are additive
over a portfolio of assets 4 . The same loan will require the same amount of provisions
whether it is a part of the vastly diversified portfolio of an internationally active bank or
of the concentrated portfolio of a small cooperative bank. While this is not a very exciting
property from the standpoint of a risk manager it has some desirable regulatory
implications. In fact, it makes it possible to envisage a relatively simple regulatory
approach to loan loss provisioning which, unlike capital regulation, needs not
differentiate among institutions of different complexity and is not affected by the
composition of banks’ loan portfolio.

Figure 1: PDF of losses, unexpected and expected losses, and economic capital

General Credit risk capital

Provisions
99th percentile

Expected Unexpected
losses losses

O A Loss B

The second implication, of statistical nature, is that provisions can be estimated

with greater precision than capital requirements, especially when the amount of
information about loan defaults is limited. In fact, the new regulatory approach set out by
the BCBS requires that capital be equal to credit losses located at given percentile levels
– such as the 1 per cent or the 0.1 per cent – of the highly asymmetric distribution of loan
losses. Provisions, instead, should be equal to the mean value of the same distribution.

4
Consider for instance a portfolio y=x1 +x2 , where x1 and x2 are two assets with the following loss
probability distribution x1 ∼(µ1 ,σ1 ) and x2 ∼( µ2 ,σ2 ). Portfolio’s unexpected losses, measured by the
standard deviation σ y = σ 12 + σ 22 + 2 ρσ 1 σ 2 , can be reduced as the correlation parameter

4
The measurement implications of this conceptual approach are relevant. In fact, the
standard error of statistical estimates of percentile levels of probability distributions – and
the associated level of capital - increases as the distribution becomes more asymmetric
and decreases only gradually with the number of available observations 5 (Kupiec, 1995).
Sample estimates of expected values of the same distributions enjoy lower standard
errors. Measures of provisions are always going to be more precise than measures of
capital and their relative precision will increases with asymmetric loan loss distributions
and with small sample sizes. The regulatory implications of these statistical facts should
not be underestimated. In fact, they suggest that loan loss provisions are simpler and
more accurate to measure than banks capital, making “risk based” provisions easier to
adopt and to enforce than capital requirements in countries where the volume of credit-
related information is relatively low, as in most emerging economies.

The third implication, of accounting nature, is that, lacking a symmetric treatment

of expected losses on both sides of the profit and loss account, bank income statements
may convey biased notions of bank profitability. For instance, allowing interest
premiums (on the asset side) but not general provisions (on the cost side) to be equal to
expected losses ge nerates an upward bias of banks’ operating income during cyclical
upswings and a downward bias during downswings 6 . The bias is reduced but not
eliminated at the level of pre-tax profits, when charges related to loan loss provisions are
fully taken into account also on the cost side. The bias, though, persists because in most
countries “general” provisions are often subject to quantitative restrictions that keep them
smaller than expected losses. In the extreme case where general provisions are equal to
zero no charges for provisions will be made in good times and all charges will be posted
as specific provisions in bad times.

goes from +1 a –1. On the contrary, the expected losses , measured by the mean losses of the portfolio
µy =µ1 +µ2 , are not affected by the number of assets in the portfolio and by the correlation in their returns.
5
In the case of the normal distribution, for which we have simple analytical expressions of the standard
deviation of the relevant sample estimates, the standard deviation of the sample mean is equal to σn -1/2
while that of the percentiles is equal to kσn -1/2 , where n defines the sample size and k is approximately
equal to 2.13 for the 5% percentile and to 3.77 for the 1% percentile. The ratio of standard deviations of the
sample mean over that of a sample percentile increases as distributions become more skewed.
6
As an example, the European Union Council 86/935 on the annual accounts of banks and other financial
institutions which is adopted by all EU member countries does not include provisions, nor specific nor
general ones, as a component of operating costs. Since the remuneration for expected losses, represented by

5
 According to widespread accounting practices “general” provisions refer to “ex-
ante” provisions and are related to future uncertain events. “Specific” provisions can
instead be seen as “ex-post” provisions, in that they refer to certain events (such as past
due payments, or other default- like events) for which a specific documentation can be
produced 7 .

“Specific” provisions are somewhat similar to write-offs and, since they can be
easily documented, are not subject to significant restrictions. “General” provisions,
instead, refer to probabilistic losses that cannot be supported by loan specific
documentation and therefore can be highly judgmental, controversial and prone to
manipulation by bank managers for opportunistic reasons or for tax avoidance purposes.
Regulatory restrictions on “general” provisions, such as regulatory ceilings, are therefore
intended to reduce the amount of possible controversies and litigations among different
groups of bank stakeholders. As a result, we observe that accounting restrictions coupled
with fiscal restrictions, intended to limit tax deductibility of general loan loss provisions,
often prevent loan loss provisions from reaching the level of expected losses.

Not always bank regulations refer explicitly to general or specific provisions but
most of the times regulatory requirements can be partitioned among “ex-ante” and ”ex-
post” provisioning. For instance, provisions triggered by past due payments could be
considered as “specific” provisions. They are, in fact, related to an observed event
(missing payments) which is one of those considered by the BCBS in its definition of
default (BCBS, 2001). Provisio ns which are, instead, required for all loans, independently
from the presence of a default event, can be considered of a “general” nature. More
difficult is to draw a line when provisions are based on cash flow considerations, which
are by their very nature more forward looking. In this case the distinction needs to be
based on a more detailed observation of the loan classification procedure.

lending rate premia, cannot be netted from operating income, operating profits tend to give an upward
biased measure of profitability.
7
The two categories of provisions follow also different accounting rules. Specific provisions appear as
charges in the income statement and generate a “contra assets’ reserve or, as in the EU countries, a
reduction of assets in the balance sheet. General provisions, instead, are registered separately in the income
statements and generate reserves on the liability side of the balance sheet.

6
3. An agency approach to general loan loss provisions

If risk weighted provisions are more easily measured than capital and if a proper
measurement of loan loss provisions could lead to a more faithful representation of the
true underlying bank profitability why are not accounting, fiscal and prudential
regulations taking advantage of these features? Our conjecture is that the definition of
loan loss provisions is affected by a host of agency problems of difficult solution and that
the existing regulatory framework, intended to minimize these agency costs, may end up
being unduly restrictive on banks provisioning practices.

Banks are no exceptions to general corporate behavior and their actions result from
the interactions of different stakeholders some of which (the banks’ outsiders: employees,
minority shareholders and the fiscal authority) are not formally sitting in the executive
boards, while others (the banks’ insiders: managers and majority shareholders) are
actively involved in the bank’s policy decisions. Imperfect control and monitoring ability
of insiders by outsiders is for banks as for nonfinancial corporations a source of agency
problems.

The allocation of banks’ operating profits among provisions, income taxes,

dividends and retained earnings is a highly judgmental decision which rests to a large
extent on manager’s autonomous judgment. The lack of transparency of these decisions
have led banks’ outsiders to find different forms of protection of their claims over banks’
profits. One form of protection is represented by legal provisions that promote minority
shareholders’ rights. La Porta et al. (2000), for example, have recently found empirical
support to an agency based explanation of corporate dividend payments and claim that
Anglo Saxon legal systems are associated to higher pay out ratios. Analogously we
suggest that higher dividend payments could come at the expense of sound provisioning
charges.

If it were not for asymmetric information it is very likely that bank managers would
set their provisions according to expected losses, reducing profits volatility by drawing
down loan loss reserves during bad times and increasing them in good times. Kim and
Santomero (1977) show, in fact, that with incomplete but symmetric information, profit

7
maximizing bank managers should follow profit smoothing strategies, setting provisions
in line with expected losses. 8

The previous considerations support the notion that asymmetric information and
the related agency costs may well be the factors that have prevented banks from adopting
a more symmetric accounting treatment of expected losses on both sides of their ledgers.

But how many are the relevant categories of bank outsiders trying to protect their
rights to banks’ profits? And how does protection of corporate outsiders affect bank
provisioning policies? We conjecture, following Laporta et al. (2000) that one important
category of outsiders is represented by minority shareholders trying to achieve higher
payout ratios. We also suggest that a second powerful outsider is represented by the fiscal
authority, that according to the state of public finances may promote more or less
stringent rules to protect tax revenues. 9 According to outsiders’ effectiveness in
protecting their claims, bank managers will revise the share of banks’ EBTDA available
for loan loss provisioning. Our hypothesis suggests, therefore, that higher shareholder
protection and higher public debt ratios to GDP could be associated on average with a
lower amount of general provisions.

As for the inclusion of the fiscal authority among bank outsiders, we have scattered
evidence that fiscal incentives to loan loss provisioning reacts to the state of public
finance. In the US, for instance, the fiscal treatment of bank provisions has followed the
evolution of the fiscal deficit. After several decades in which bank regulation allowed
banks to built tax exempt provisions, based on historical worst case scenarios, the higher
fiscal deficits of the 1980s have been mirrored by a progressive scaling down of tax
exemptions and by their final cancellation in 1986 (Conway and Siegenthaler, 1987). The
problem is not alleviated by public ownership of the banking sector. In fact, the

8
Kim and Santomero (1993) show that when the observation of loan quality is costly and is subject only to
periodic reviews (by the bank or by bank supervisors) the positive association of bank earnings and
provisions is the simple result of statistical forecasting. The positive association remains in place also when
the uncertainty is extended to the distribution of default frequencies, if bankers follow the rational approach
of adapting their priors on the basis of new historical evidence, through a Bayesian process.
9
Countries where public ownership of the banking sector eliminates the agency conflict between the
management and the fiscal authority still face a conflict between sound management (profit maximization)
and pursue of extra-managerial objectives (unrelated to profit maximization). In the extreme case of full
state ownership, taxation, as the most effective means of appropriation of banks earnings, still conflicts
with the maximization of banks’ value.

8
heightened perception of an implicit guarantee is likely to further discourage sound
provisioning policies exposing banks to the same instability caused by excessive
outsiders protection10 .

What are the welfare implications of this agency approach to profit allocation? La
Porta et al. (2000) claim that, differently from what suggested by Modigliani and Miller
original work, dividend policy affects the investment policy of the firm by influencing the
frequency of its recourse to the market and therefore increasing the effectiveness of
market discipline and the efficiency of marginal investments. They also suggest that
corporate outsiders would be penalized through asset diversion, transfer prices and other
appropriation mechanisms on the part of corporate insiders, unless they are given the
right to share the firm’s profits in accordance with some pro rata mechanism such as
defined by dividend payment policies.

When we move from the corporate to the banking sector does the same kind of
considerations apply, or should additional elements be brought into the picture? In the
first place, banks’ high leverage makes them more vulnerable to asset values volatility,
suggesting the need for larger provisions. It is therefore conceivable that lack of
differentiated patterns of outsiders protection in the corporate and in the banking sector
may lead to under provisioning with negative effects on bank stability.

Second, excessive fiscal pressures may reduce, instead of increasing, the present
value of net fiscal revenues. In fact, should the tax code discourage provisioning and
increase bank fragility, the fiscal authority could be faced in the future with an increased
cost of the safety net vastly exceeding the present fiscal cost of adequate tax incentives to
sound provisioning practices.

Third, less developed institutional settings, lacking the richer set of controls that
goes under the name of market discipline, may have to resort more extensively to
prescriptive measures, like mandatory payments, to protect corporate outsiders. Such a
prescriptive approach may unduly restrict risk management flexibility with ultimate

10
Countries where public ownership of the banking sector eliminates the agency conflict between the
management and the fiscal authority still face a conflict between sound management (profit maximization)
and pursue of extra-managerial objectives (unrelated to profit maximization). In the extreme case of full

9
negative effects on banks solidity. Finally, the pervasive prudential regulation of the
banking sector seems to make less compelling the argument in favor of dividend
protection as a form of minority shareholders protection against rapacious managers.

Summarizing, the agency approach provides a rationale for some relevant features
of the regulatory framework for loan loss provisions that we observe in most countries.
The same approach would suggest that the scale of benefits associated to the protection of
outsiders claims in the corporate sector may not be the same when considering the
banking sector. More specifically, it seems that in the case of banks, a balance needs to
found between the protection of outsiders and the encouragement of loan loss
provisioning.

An implication of the agency approach is that if recent advances in the area of

credit risk measurement are bound to reduce the information asymmetries that
characterize the banking sector, also the introduction of a new risk based approach to
provisioning should be seen as easier. A concurrent positive development is represented
by the worldwide process of fiscal consolidation that may favor tax deductions of loan
loss provisions up to levels commensurate to the expected losses.

4. Income smoothing properties of loan loss provisioning

Loan loss provisions in line with expected losses would not only remove
accounting distortions in the representation of bank profitability, but could also improve
bank stability. In fact, when outsiders find their claim protected during periods of positive
earnings but are not committed to any loss sharing mechanism during economic
downturns, banks tend to pay excessive dividends in good times instead of increasing
capital and reserves as the following simulation will help to visualize. To this end we
define, first, the main components of lending rates and then use them in a schematic
representation of the profit and loss statement, to be simulated over a full economic cycle.

state ownership, taxation, as the most effective means of appropriation of banks earnings, still conflicts
with the maximization of banks’ value.

10
 Profit maximizing banks set their lending rates (rL) as a sum of the risk- free interest
rate (rB), of the (unconditional) expected loss ratio E(d) and of the risk premium (k). 11
Expressing the expected losses E(d) as a rate of return per unit of time we have the
following expression:

rL = rB + E(d) + k + c. (1)

The sum of the risk- free rate (rB ) and the risk premium (k) provides the
remuneration for the cost of borrowed funds and of capital. We also assume that the
remuneration of unit operating costs (c) times the volume of outstanding loans (L) fully
covers the total amount of operating costs (OC) so that c*L=OC. The E(d) component is
instead the yearly amount of provisioning that is needed to match the average amount of
losses faced by each loan over the economic cycle. This simplified representation of
banks’ interest setting shows that banks will experience excess returns in good times
when the default rate is lower than E(d) and will not be able to cover their costs when the
default rate is higher than its average level.

The spread between the lending rate and the average cost of funding (rD) times the
amount of outstanding loans (L) gives the net interest income (NII). Subtracting the value
of loan losses (∆BL) we get the bank earning before taxes (π). When loan loss provision
are kept equal to zero the pre-tax profit takes the form described in equation 2, where
loans and bad loans carry a superscript indicating that, differently from other variables,
they are stochastic variables with a cyclical pattern:

≈ ≈
π = L[(rB + E( d ) + k ) − rD ] − ∆ BL
(2)
≈
≈ ≈

= L[(rB + k ) − rD ] +  L⋅ E (d ) − ∆ BL 
 

Equation 2 shows that during cyclical downswings an increase of bad loans and a
reduction of the interest income (due to the reduction of outstanding loans) will cumulate
their negative effects on pre-tax profits. During economic booms a higher level of loans
will, on the contrary, generate higher interest revenues while write offs below average
will provide an additional boost to profits.

11
The risk premium under the CAPM model could be quantified by the relation k = β (r m-rB), where r m is

11
 Let’s now turn to the case of partial provisioning where loan loss provisions are
set equal to a fraction γ of the expected default ratio E(d):

≈ ≈
 ≈ ≈

π = L[(rB + E( d ) + k ) − rD ] − ∆ BL −  γ ⋅ E (d ) ⋅ L − ∆ BL  (3)
 

≈ ≈
= L[(r B + k ) − rD ] + (1 − γ ) ⋅ E (d ) ⋅ L if LLR > 0 (3A)

≈
 ≈ ≈

= L[(r B + k ) − rD ] −  E ( d ) ⋅ L − ∆ BL  if LLR = 0 (3B)
 

In this case banks will be willing to set aside provisions in excess of write offs during
cyclical upswings. The last term in parenthesis of equation 3 represents the amount of net
provisions as given by the difference between gross provisions (γE(d)L) and write offs
(∆BL). Net provisions are positive when write offs are smaller than the provisions and
Loan Loss Reserves (LLR) increase. When write offs rise, during cyclical contractions,
net provisions are negative which means that previously accumulated loan loss reserves
are gradually drawn down. This pattern of general provisions, labeled “dynamic
provisioning”, has recently been introduced by the Spanish banking authorities (Poveda,
2000) and forcefully advocated by the French Commission Bancaire (Commission
Bancaire, 2000) to help preventing cyclical fluctuations in the supply of bank credit to the
economy. When loan loss reserves (LLR) are fully depleted (equation 3B) we revert to
the case of no provisions described in equation 1. It is interesting to observe that until
reserves are depleted (equation 3A) the cyclical impact of write offs (∆BL) on profits has
been eliminated.

Lets now consider the last case in which provisions are set equal to the level of
the expected default ratio:

~  ~
π = L [(rB + E( d ) + k ) − rD ] − ∆ BL −  E ( d ) ⋅ L − ∆ BL 
~ ~
  (4)

= L [(rB + k ) − rD ]
~

the rate of return of the market portfolio .

12
In this case, having se the level of provisions equal to the expected default ratio, the draw
from loan loss reserves is never larger than the outstanding stock so that the case of
previous equation 3B never obtains. As in the case of equation 3A the cyclical impact of
write offs on profits has been completely eliminated. In addition, we notice that now also
the effect of the asymmetric treatment of expected losses on the revenue and on the cost
side of the income statement, represented by the term [(1-γ)E(d)L], has been washed out.
With full provisioning the only source of banks’ earnings variability is the unavoidable
oscillation of the demand for loanable funds over the economic cycle.

To visualize the impact of the three provisioning regimes on bank profitability

and capital we have simulated the pattern followed over the cycle by bank loans,
provisions, operating income, taxes and profits. For this purpose we have considered an
hypothetical loan portfolio where loans are implicitly rolled over on a yearly basis unless
the borrower defaults or the loan is reimbursed. We also have assumed that the amount of
write offs increases when the demand for loans is weaker and that as a result of these two
forces the NPL ratio oscillates between 4 and 18 per cent of total assets over the cycle.
(Fig. 2). While default ratios of this entity are not infrequent in developing countries our
results would not change for countries where, due to a lower cyclical instability and to a
better risk management, NPL ratios are less volatile. 12 Figure 3 shows the oscillations of
net provisions (fixed provisioning rate less effective write offs) as defined in equations 3
and 4 together with the fluctuations of the operating income. 13 When gross provisions are
set equal to the (unconditional) expectation of loan losses, net provisions show a regular
pattern that follows that of the operating income. On the contrary when gross provisions
are set equal to a fraction of the value of the (unconditional) expectation of loan losses
net provisions follow a highly irregular pattern.

As a result of the interaction of write-offs and net provisioning, in the three

provisioning regimes, described by equations 2, 3 and 4, before tax earnings display the
oscillations described in Figure 4.

12
For expository purposes the simulation is conducted around a stationary time trend but results would not
be affected considering oscillations of bank lending around a growing time trend.
13
A full description of the cost and income ratios used in the simulations is described in the footnote to
Table 1.

13
 Figure 2: Total loans, bad loans and NPL ratio

120 20%
100
15%
80
value

60 10%
40
5%
20
0 0%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Bad Loans Total Loans NPL ratio (right scale)

Figure 3: Operating profits and provisions

10 15

5
10
value

0
5
-5

-10 0
11

13

15

17

19

21

23

25

27

29
1

partial net prov. full net prov. op. inc. (right scale)

Figure 4: Pre-tax Earning

10
5
values

0
-5

-10
1

11

13

15

17

19

21

23

25

27

29

no provis. partial provisions full provisions

14
 Assuming an income tax ratio of 20 per cent, income taxes would follow the
pattern reported in Figure 5: smooth for the full provisioning regime; less regular for the
other two regimes. Net profits would then be partitioned between retained earnings and
dividend payments according to the selected pay out ratio. Assuming a pay out ratio
equal to 0.5 we can simulate the dynamic of banks capital as a result of retained earnings
during periods of positive profits and of capital reductions during periods of losses. With
full provisioning the above described dynamics leads to a rather stable evolution of
retained earnings without any reduction of the existing capital over the cycle (Figure 6),
while an alternating sequence of retained earnings in good times and of capital reductions
in bad times appears to prevail in the other two regimes.

Figure 5: Income Taxes

2
2
values

1
1
0
-1
1

11

13

15

17

19

21

23

25

27

29
no provis. partial provisions full provisions

Figure 6: Capital reductions (-) and retained earnings (+)

retain. earn.

4
2
0
capital changes

-2
-4
-6
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29

no provisions partial provisions full provisions

15
 The simulation shows that whenever banks follow a sound pricing policy but do
not fully provision for (unconditional) expected losses an impact on capital is to be
expected. The question is whether capital reductions are going to be replenished by
retained earnings during cyclical upturns. Table 1 shows that when bank outsiders share
the earnings but not the losses a progressive erosion of bank capital takes place: the sum
of retained earnings is in fact smaller than the reduction of capital both in the no
provisions and in the partial provisions regime. Table 1 reports few additional results.
The large earnings fluctuations generated by inadequate provisioning do not allow bank
outsiders to clearly perceive whether their share in the banks income is different from
zero. In fact only in the case of full provisioning the tax authority (taxes) and the
shareholders (net profits) achieve positive results that exceed two times the standard
deviation and can be considered statistically different from zero with a reasonably high
level of confidence. In addition, the higher volatility of profits observed in the case of
null and partial provisioning is likely to generate a higher cost of capital which would
make capital shortages even more severe in these two regimes.

Let’s now briefly consider the implication of setting minimum capital

requirements equal to the sum of expected and unexpected losses as suggested by the new
capital regulation proposed by the BCBS. The main implication is that the amount of
financial resources required to dampen cyclical fluctuations would increase. In fact the
level of capital requirement would now include the level of expected losses but would not
allow loan loss reserves to adjust over the cycle and would not therefore have the
smoothing properties of “dynamic provisioning” practices. Using as an example the
partial provisioning regime of equation 2 we would have that the reversion to the high
cyclical instability, which follows from loan loss reserves depletion (LLR=0), would now
be triggered at a higher level of reserves (LLR=X, with X>0). From an incentive
perspective the new regulation would have the negative implication of reducing the
amount of reserves granted tax exemption that can be used for income smoothing14 .

14
To include reserves as a component of minimum capital requirement amounts to set for them a point
requirement instead of an average requirement. The destabilizing effects of point requirements have been
well understood in the regulation of compulsory reserves on bank deposits that in most countries are
required to hold “on average over the maintenance period” but not for every single day, stabilizing bank
liquidity fluctuations over the maintenance periods.

16
 Summarizing, it could be said that to the extent that the notion of regulatory
capital coincides with that of minimum capital requirements, capital requirements should
deal only with unexpected losses and should not include general loan loss reserves as a
component of regulatory capital. If, instead, regulatory capital were intended as an
average capital requirement it could be properly be referred to both expected and
unexpected components and have general loan loss reserves as a component. The present
situation whereby the objective of minimum capital requirements is achieved by a
composition of regulatory capital consistent with an average requirement is likely to be
suboptimal.

5. The estimation procedure

In order to verify the nature of the relationship between banks’ earnings and to
test our hypotheses about the determinants of banks’ provisioning decisions, we have
estimated the following econometric relationship:

LLPi ,t = α + β ⋅ BSV i, t + γ ⋅ CMI i, t + δ ⋅ CII i + η ⋅ CBD i + ϑ ⋅ TDt + ε i ,t (5)

where loan loss provisions (LLP) for the bank i at time t are a function of bank specific
variables (BSV), of a selected number of the bank’s own country macro indicators (CMI)
and institutional indicators (CII) and of time specific dummies (TD). As an alternative to
country institutional indicators (CII) we have used country or bank dummies (CBD) as a
proxy for institution or country specific factors.

To test the robustness of the econometric results we have estimated equation 5

with different regression techniques. We have first run a cross section OLS regression
based on the average value of bank level variables (the “between” effect model). We
have then replicated the same regressions as a pooled OLS in order to test for the effects
of time invariant variables, such as the legal and institutional indicators, that cannot be
tested in a fixed effect panel estimation. Finally we have run a panel fixed effect
estimation (the “within” effect model) without legal indicators.

Both pooled OLS and fixed effect panel regressions have been estimated first on
the whole sample and then separately for the two sub-samples represented by banks

17
located in G10 countries and by those located in non-G10 countries. As an additional
check of robustness, the set of estimates for the three samples (total banks, G10 banks,
non-G10 banks) has been replicated for shorter sample periods, smaller set of countries,
and using more stringent filtering procedures for outliers exclusion. All regressions have
been estimated making use of the White correction for heteroskedasticity.

5.1 The data

The data include banks’ balance sheet information and proxies for country
specific macroeconomic and institutional features over the period 1988 to 1999. We
included in our sample the countries that had over the sample period at least three
commercial banks recorded in the Bankscope database and that are also reported in the
La Porta et al. (1998) dataset on legal features. We have then eliminated the banks that
over the sample period had less than three consecutive years of balance sheet
observations, in order to control for the consistency and quality of bank reporting.
Finally, in order to minimize the effects of measurement errors we have excluded all the
outliers by eliminating the bank/year observations that did not meet one of the following
conditions:
- a ratio of loan loss provisions over total assets smaller than or equal to 10%;
- a ratio of earnings before provisions over total assets smaller than 10%;
- a ratio of total loans over total assets bigger than 10 % and smaller than 90%;
- a growth rate of bank loans in real terms smaller than 50% in absolute value .

The resulting sample included 36 countries 15 , with a total of 1176 banks, 372 of
which from non-G10 countries. The dependent variable is represented by the ratio of loan
loss provisions over total assets. Explanatory variables include firm specific determinants
and country specific determinants. At the firm level we have considered as a proxy of
bank’s EBTDA the value of pre-tax earnings net of loan loss provisions, and as proxies of
credit risk exposures the ratio of banks’ loans over total assets and the real growth rate of
bank loans. The first indicator takes smaller values for institutions that invest a

15
The final sample non-G10 countries considered are Australia, Chile, Colombia, Denmark, Finland,
Greece, Indonesia, Ireland, Israel, Jordan, Korea, Malaysia, Mexico, New Zealand, Norway, Pakistan, Peru,
Philippines, Portugal, Singapore, South Africa, Spain, Thailand, Turkey, Uruguay. The G-10 countries are
Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, Switzerland, United Kingdom, and
United States.

18
substantial share of their portfolio in “riskless” government bonds and are therefore less
risky. The second also is positively associated to risk, given that rapid growth of bank
lending is generally associated with lower monitoring efforts and a deterioration of the
quality of loan portfolios. A prudent bank is expected to show a positive association
between the amount of loan loss provisions and the value of EBTDA and of the two risk
indicators.

At the country level we have considered, in addition to individual country

dummies intended to catch the unique features of national economic and institutional
features, the value of per capita GDP, as an additional proxy of institutional quality, and
the ratio of public debt over GDP as a measure of fiscal pressure. Both indicators are
expected to be negatively related to loan loss provisioning. A high level of per capita
GDP should, in fact, signal a high quality institutional setting with adequate incentives
for debtors to fulfill their obligations and one where banks can lower their provisions. A
high level of public debt, instead, signals a propensity of the fiscal authority to widen the
tax base and to limit tax exemptions for banks’ loan loss provisions. It is also to be
expected that the negative fiscal effect will be stronger for countries with a large volume
of financial intermediation, where the banking system is an important source of fiscal
revenues.

Among the indicators of legal and regulatory framework we have considered the
traditional indicators of common law, creditor rights and rule of law as measured by La
Porta et al. (1998). The two first indicators are expected to be associated with higher
protection of minority shareholders and of creditors rights and should therefore be
positively related to the amount of dividends (La Porta et al., 2000) and negatively related
to the value of loan loss provisions. Finally, the indicator of Rule of Law has been
included to catch the effect of more severe enforcement practices for any given level of
creditors or minority shareholders protection. The expected sign on the amounts of loan
loss provisions is positive.

Table 2 provides some descriptive statistics about the variables in our estimation
sample. As a ratio to total assets, loan loss provisions are on average equal to half a
percentage point (standard deviation of 0.8 per cent) and earnings before taxes and

19
provisions are equal to 1.6 per cent (standard deviation of 1.2 per cent). Loans represent
an average 58.3 per cent share of banks’ portfolios and their average real rate of growth is
equal to 4.5 per cent. Countries have an average real per capita GDP of 2,200 US dollars,
ranging from a minimum of 500 to a maximum of 45.000 US dollars, and an average
ratio of public debt to GDP of 45 per cent, ranging from a minimum of 3 to a maximum
of 135 per cent. A description of the sources and of the construction of each individual
variable is provided in the Appendix.

5.2 Estimation Results

The estimation results, reported in Tables 3 to 7, show a considerable degree of

stability across the different estimation approaches both in terms of size and sign of the
estimated coefficients. Tables 3 to 6 report the outcomes of the same four alternative
specifications of equa tion 5 for the cross section and the pooled OLS. Column 1 shows
the results of a regression of loan loss provisions against bank specific variables and
country and time dummy variables; columns 2 and 3 illustrate the effects of adding the
two macroeconomic variables to the picture; column 4 shows the impact deriving from
the substitution of country specific dummy variables with legal regime specific dummy
variables.

Cross section estimates (Table 3) show a positive relationship between the ratio of
loan loss provisions over total assets and bank earnings, confirming previous results for
the US market supportive of an income smoothing pattern (Greenawalt and Sinkey,
1988). A similarly strong positive relation is displayed by the share of loans over total
assets, while a negative relation prevails with respect to the loan growth rate.

Provisions, therefore, seem to exhibit the desirable positive association with

earnings but their association with the amount of risk embedded in banks balance sheets
is somewha t contradictory. The ratio of loans over total assets has the expected positive
sign, while the loan growth rate has a negative sign implying that provisions tend to
decrease as a share of total assets when the increase of new lending and the decrease of
monitoring tend to reinforce the risk exposure of banks portfolios. Although some mild
correlation is present among these variables, their statistical significance and estimated
values have shown not to be sensitive to the inclusion or exclusion of each of them.

20
 The indicator of the fiscal pressure, represented by the public debt over GDP is
also strongly significant with the expected negative sign, supporting the hypothesis that a
stronger incentive to widen the tax base may negatively affect banks provisioning
patterns. The per capita GDP, instead, does not turn out to be statistically significant but
enters with expected sign. In all the previous specifications country dummies turn out to
be strongly jointly significant. Among the indicators of the legal system we find evidence
of lower bank loan loss provisions in common law countries and a positive one with the
effectiveness of enforcement practices as summarized by the rule of law indicator. The
indicator of creditor rights, instead, does not appear to exert an independent effect
although it enters the equation with the expected sign.

Although the cross section estimates appear very supportive of our priors, our
interest for provisioning practices over the cycle requires a careful verification of the
robustness of these results to the introduction of the time dimension in the estimation
sample.

When replicating the estimation of the previous four regression specifications

with a pooled OLS we find a widespread confirmation of previous results with only
minor changes in the values of point estimates. As reported in table 4 the coefficient
associated to bank earnings shrinks on average from 0.23 to 0.13, but remains strongly
significant.

The next step of the analysis is to verify to what extent these results hold for
countries at different level of institutional development. Different levels of information
availability about borrowers behavior, different levels of portfolio diversification and
other factors may significantly affect the incentive of bank customers to fulfill their
obligations requiring different provisioning patterns. We replicate therefore the previous
regressions dividing the previous sample in the two mutually exclusive sub samples
represented by banks active in G10 countries and those active in non-G10 countries.

Estimation results for G10 banks are reported in Table 5. They show, again, a
large convergence with those from the two previous sets of regressions. The point value
of the coefficient related to bank earnings is now higher – 0.21 from 0.13 - suggesting
that income smoothing behavior may be more pronounced in more developed financial

21
systems. Also the indicators of legal and institutional features appears to be highly
significant and each with the expected sign.

The picture changes considerably when we turn to non-G10 countries, as showed

in Table 6. Most notably the relationship between bank earnings and loan loss
provisioning seems to disappear. The coefficient turns negative and looses any statistical
significance. The fact that the coefficients associated with the proxies of risk exposure are
still significant with the same signs of previous equations seems to suggest that the
average amount of provisions is not dissimilar between the two groups of countries but
that there is a difference in their timing along the cycle, such that an income smoothing
pattern prevails only in G10 countries. It is also interesting to observe that the public debt
to GDP ratio maintains its negative effect, not dissimilarly from G10 banks, and that also
the indicators of a common law legal system maintains its relevance. The same
regressions has been run also for non-G10 OECD countries to verify whether the results
could have been driven by countries in the lowest income category but results of table 6
were widely confirmed.

As a final test of robustness we have removed the constraint of a common

intercept for all banks from the same country, implicit in the OLS pooled regressions and
we have run a fixed effect panel regression. Interestingly, the fixed effect regression for
the whole sample shows that the bank earnings variable looses statistical significance,
similarly to what we have found previously for non-G10 countries, while the risk
indicators appear solidly anchored to their signs and values. Based on the intuition
provided by the simulations of Section 4 we have tried to distinguish the provisioning
patterns during phases of positive and of negative earnings. More specifically we have
interacted the earning variable with a dummy taking unit value when earnings are
negative and null elsewhere. As expected an asymmetry of behavior has emerged, with
statistically significant coefficient for both profits and losses. Still the negative sign of the
coefficient of the interactive dummy for bank losses appears counterintuitive: negative
earnings time a negative coefficient generate in fact higher provisions – instead of the
expected lower one – during cyclical downswings. The replication of the same regression
for G10 and non-G10 banks seems to provide the clue.

22
 The fixed effect panel regression for G10 does not show any of the previously
discussed asymmetries: banks earnings enter significantly in the equation and negative
earnings do not have any independent effect. The whole asymmetry is in fact
concentrated in the non-G10 component of the sample where we observe both a positive
level of provisioning during upswings (and higher than for G10 banks) and an even
higher (not lower) one during downswings. This evidence is consistent with inadequate
provisioning of non-G10 banks that leads to delayed and higher provisioning during
downturns. Loan loss provisions therefore increase when earnings fall.

In addition to the cyclicality implications of fixed effect panel estimates, we

should recall that the negative impact of the fiscal pressure indicator is also strongly
supported and is robust to the inclusion (as reported in Table 7) and to the exclusion of
per capita GDP. Overall, the collected empirical evidence support quite robustly our
initial guesses. The preva iling incentive structure significantly affects the pattern of banks
loan loss provisioning with potential impacts on banks financial fragility. Over our
estimation sample, though, the incentive structure has forced a general build up of
provisions during cyclical downturns only for banks located in non-G10 countries.

6. Conclusions

This paper has adopted an agency approach to bank loan loss provisioning similar
to that recently used to explain dividend payments in La Porta et al. (2000). The agency
approach claims that the amount of legal protection granted to firm’s outsiders affects the
allocation of a firm’s earnings. In our case we restrict the attention to banking firms and
extend the class of firm outsiders, traditionally represented by minority shareho lders, to
include an additional and powerful player: the fiscal authority.

While it is well known that the fiscal authority may affect relevant business
decisions for non financial firms, this is even more so for banks. Excessive restrictions or
fiscal disincentives to adequate provisioning may result in the weakening of banks’
financial stability. Banks are in fact considerably more leveraged than manufacturing
firms, and need to devote a larger share of their operating profits to cover expected future
asset depreciations. Banks, though, are also more opaque generating relevant agency

23
costs and the request for higher protection of ”outsiders” claims over banks’ earnings.
Stronger minority shareholders will be able to reap higher dividend payments and a more
assertive fiscal authority will obtain higher tax payments. In the case of the banking
system, the fiscal authority though needs to properly balance the benefits of higher
present fiscal revenues and of larger future costs of the safety net caused by weaker
banking systems.

The econometric evidence shows that the protection of outsiders’ claims (minority
shareholders in common law countries and fiscal authority in high public debt countries)
has negative effects on the level of bank provisions. While these effects do not seem to
have had a negative impact on the provisioning pattern over the sample period for banks
located in G10 countries, this is not so for banks located in non-G10 countries. The latter,
in fact, have on average experienced higher flows of loan loss provisions during periods
of negative profitability signaling an inadequate amount of provisioning during cyclical
upturns.

Lacking adequate incentives for sound provisioning banks may not be able to
shelter profits and capital from negative - but expected – repercussions of cyclical
downturns. Where cyclical oscillations are particularly wide, as it is the case in less
developed economies, inadequate provisioning may very quickly lead to capital shortages
with undesirable pro-cyclical effects on the level of the economic activity. Our results
suggest that sound provisioning should be considered as a component of capital
regulation and that only through sound provisioning practices minimum capital regulation
can loose its pro-cyclical features.

The recent proposal of a new Capital Accord set out for consultation by the BCBS
does not address the need for a risk based regulation of bank provisions and does not
provide new incentives to a proper treatment of expected losses. It confirms explicitly
what was only implicit in the 1988 Capital Accord, that is, that capital is intended to deal
both with expected and unexpected losses and that therefore general loan losses should be
considered as a component of regulatory capital. By removing this anomaly the capital
accord can be expected to lose many of the pro-cyclical features that have negatively
characterized it in the past.

24
Appendix: Data Definition and Sources

I. Definition
Provisions/Assets = Loan Loss Provisions / Total Assets
Earnings before Provisions / Assets = (Profit before Tax + Loan Loss
Provisions) / Total Assets
Loans / Assets = Total Loans / Total Assets
Loans in Real Terms = Total Loans / CPI
Loans Growth Rate = [Loans in Real Terms (-1) - Loans in Real Terms]/ Loans
in Real Terms (-1)
GDP per Capita (in Thousands 1995 US Dollars) = GDP at market prices
(constant 1995 US Dollars) / 1000*(Population, Total)
Debt / GDP = Public Debt / Gross Domestic Product

II. Sources
Income Statement and Balance Sheet Items taken from Bank Scope
Loan Loss Provisions – Bank Scope, summary code No: 2095
Profit before Tax – Bank Scope, summary code No: 2105
Total Loans – Bank Scope, summary code No: 2000
Total Assets – Bank Scope, summary code No: 2050
Series from the IMF and the World Bank
CPI (1995) = 100 – IFS line 64
GDP at market prices (constant 1995 US Dollars) – World Development
Indicators.
Population, Total – World Development Indicators.
Public Debt – IFS line 88, GFSY and OECD Analytical Indicators – Maastricht
definition (for EU countries).
Gross Domestic Product – IFS line 99b
Data from La Porta et al. (1998)
Common Law – La Porta et al. (1998)
Rule of Law - La Porta et al. (1998)
Creditor Rights - La Porta et al. (1998)

25
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______ (2000), “Financial Stability and the Basel Capital Accord”, March, mimeo.
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Borio, Claudio, C. Furfine and Ph. Lowe, (2001) “Procyclicality of the Financial System and
Financial Stability: Issues and Policy Options”, BIS, mimeo.
Chiuri, Maria Concetta, G. Ferri and G. Majnoni, (2001), “The Macroeconomic Impact of
Capital Requirements in Emerging Economies: Past Evidence to Assess the Future”,
Policy Research Working Paper, The World Bank, forthcoming.
Commission Bancaire, (2000), “From Expected Losses to Dynamic provisioning”, November,
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Conway, Francis X. and W.A. Siegenthaler, (1987), “Loan Loss Reserves: Tax, Regulatory
and Adequacy Issues”, The Journal of Commercial Bank Lending, September, pp. 4-15.
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Kim, Daesik and A. Santomero, (1993), “Forecasting Required Loan Loss Reserves”, Journal
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Kupiec, Paul H., (1995), “Techniques for Verifying the Accuracy of Risk Measurement
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19.

27
 Table 1: Simulated Earnings with Different Provision Rules
(percent of total assets)

No provision Partial provision Full provisions

Average values (standard deviations in parenthesis)

Earnings before taxes 1.56 1.56 1.56

(5.44) (4.54) (0.32)
Taxes 0.64 0.60 0.31
(0.72) (0.49) (0.06)
Net profits 0.92 0.96 1.25
(4.76) (4.07) (0.26)
Retained earnings 1.28 1.20 0.63
(1.44) (0.97) (0.13)

Cumulative variations over a full cycle

Earnings before taxes 18.8 18.8 18.8

Taxes 7.7 7.2 3.8
Net profits 11.1 11.5 15.0
Retained earnings 15.4 14.4 7.5
Capital shortages -19.7 -17.4 0

The simulations are done along an hypothetical cycle, assuming an NPL ratio equal to 11 percent; a full
provisioning ratio of 11 percent; a partial provisioning ratio of 7.7 percent; a tax ratio of 20 percent; a pay-
out ratio of 50 percent.

Table 2: Regression Variables - Summary Statistics

Mean Std. Dev. Min Max

Variable No. Obs (%) (%) (%) (%)

Provisions / Total Assets 5957 0.54 0.82 -5.86 9.88

EBTDA / Total Assets 5957 1.63 1.20 -6.49 9.81
Total Loans / Total Assets 5957 58.29 15.96 10.09 89.98
Loans Growth Rate 5957 4.52 16.45 -49.95 49.93
GDP per Capitaa 5957 220.9 101.0 5.10 449.9
Debt / GDP (%) 5957 53.39 24.53 3.73 135.15

a
Hundreds of constant 1995 US dollars.

28
 Table 3: Cross-Section Regressions

The regressions are estimated using ordinary least squares with robust standard errors pooling average bank data
across 36 countries for the 1988 – 1999 time period. The first two regression also include country dummy
variables for which only the F-Test of joint significance is reported. The dependent variable is the ratio of
provisions over total assets. Detailed variable definitions and data sources are given in the appendix. Standard
errors are given in parentheses.

Dependent Variables (1) (2) (4) (3)

Bank Indicators
0.230*** 0.230*** 0.231*** 0.211***
EBTDA / Total Assets
(0.017) (0.010) (0.016) (0.016)
Total Loans / Total Assets 0.010*** 0.010*** 0.009*** 0.008***
(0.001) (0.002) (0.001) (0.001)
Growth Rate of Loans -0.015*** -0.014*** -0.014*** -0.016***
(0.002) (0.002) (0.002) (0.002)
Macro Indicators
Ln (Debt / GDP) -0.762*** -1.040*** -0.017*
(0.187) (0.265) (0.040)
Ln (real GDP per capita) -1.699 -0.087*
(1.149) (0.045)
Institutional Indicators
Common Law -0.232***
(0.046)
Rule of Law 0.033***
(0.022)
Creditor Rights -0.020
(0.017)

Joint significance tests

Country dummies F (35,1128) 9.56*** 10.15*** 10.09*** -
Prob (F) (0.000) (0.000) (0.000) -
Time dummies F (9,1128) 8.17*** 7.98*** 2.74*** 2.64***
Prob (F) (0.000) (0.000) (0.004) (0.005)
Adj. R2 0.40 0.41 0.24 0.24
No. Obs 1176 1176 1176 1173

*
/ ** / *** Indicate significance levels of 10, 5 and 1 percent respectively.

29
 Table 4: Pooled Regressions

The regressions are estimated using ordinary least squares with robust standard errors pooling time-series bank
data across 36 countries for the 1988 – 1999 time period. The first two regression also include country dummy
variables for which only the F-Test of joint significance is reported. The dependent variable is the ratio of
provisions over total assets. Detailed variable definitions and data sources are given in the appendix. Standard
errors are given in parentheses.

Dependent Variables (1) (2) (3) (4)

Bank Indicators
0.136*** 0.134*** 0.135*** 0.136***
EBTDA / Total Assets
(0.024) (0.024) (0.024) (0.023)
Total Loans / Total Assets 0.011*** 0.011*** 0.011*** 0.009***
(0.001) (0.001) (0.001) (0.001)
Growth Rate of Loans -0.013*** -0.013*** -0.013*** -0.013***
(0.001) (0.001) (0.001) (0.001)

Macro Indicators
LN (Debt / GDP) -0.261*** -0.706*** -0.027
(0.066) (0.124) (0.023)
LN (real GDP per capita) -2.664*** -0.113***
(0.498) (0.025)

Institutional Indicators
Common Law -0.209***
(0.028)
Rule of Law 0.043***
(0.013)
Creditor Rights -0.020*
(0.011)

Joint significance tests

Country dummies F (35,5909) 21.54*** 22.12*** 23.12*** -
Prob (F) (0.000) (0.000) (0.000) -
Time dummies F (9,5909) 33.71*** 30.55*** 8.33*** 17.18***
Prob (F) (0.000) (0.000) (0.000) (0.000)
Adj. R2 0.23 0.24 0.25 0.16
No. Obs 5957 5957 5957 5941

*
/ ** / *** Indicate significance levels of 10, 5 and 1 percent respectively.

30
 Table 5: Pooled Regressions – G10 Countries

The regressions are estimated using ordinary least squares with robust standard errors pooling time-series bank
data across G10 countries for the 1988 – 1999 time period. The first two regression also include country dummy
variables for which only the F-Test of joint significance is reported. The dependent variable is the ratio of
provisions over total assets. Detailed variable definitions and data sources are given in the appendix. Standard
errors are given in parentheses.

Dependent Variables (1) (2) (3) (4)

Bank Indicators
0.207*** 0.207*** 0.207*** 0.210***
EBTDA / Total Assets
(0.028) (0.027) (0.027) (0.027)
Total Loans / Total Assets 0.009*** 0.009*** 0.009*** 0.009***
(0.001) (0.001) (0.001) (0.001)
Growth Rate of Loans -0.010*** -0.010*** -0.010*** -0.010***
(0.001) (0.001) (0.001) (0.001)

Macro Indicators
LN (Debt / GDP) -0.257** -1.264*** -0.512***
(0.119) (0.202) (0.048)
LN (real GDP per capita) -7.019*** -1.505***
(1.121) (0.082)

Institutional Indicators
Common Law -0.577***
(0.039)
Rule of Law 0.126***
(0.023)
Creditor Rights -0.083***
(0.014)

Joint significance tests

Country dummies F (9,4109) 55.26*** 55.17*** 48.38*** -
Prob (F) (0.000) (0.000) (0.000) -
Time dummies F (9,4109) 34.41*** 22.89*** 5.06*** 9.56***
Prob (F) (0.000) (0.000) (0.000) (0.000)
Adj. R2 0.27 0.27 0.28 0.27
No. Obs 4041 4041 4041 4041

*
/ ** / *** Indicate significance levels of 10, 5 and 1 percent respectively.

31
 Table 6: Pooled Regressions – Non G10 Countries

The regressions are estimated using ordinary least squares with robust standard errors pooling time-series bank
data across 27 non G10 countries for the 1990 – 1999 time period. The first two regression also include country
dummy variables for which only the F-Test of joint significance is reported. The dependent variable is the ratio of
provisions over total assets. Detailed variable definitions and data sources are given in the appendix. Standard
errors are given in parentheses.

Dependent Variables (1) (2) (3) (4)

Bank Indicators
-0.028 -0.023 -0.027 -0.035
EBTDA / Total Assets
(0.038) (0.038) (0.038) (0.034)
Total Loans / Total Assets 0.012*** 0.012*** 0.011*** 0.011***
(0.002) (0.002) (0.002) (0.002)
Growth Rate of Loans -0.017*** -0.017*** -0.016*** -0.014***
(0.001) (0.001) (0.001) (0.001)

Macro Indicators
LN (Debt / GDP) -0.259** -0.618*** -0.027
(0.082) (0.136) (0.032)
LN (real GDP per capita) -2.334*** -0.009
(0.563) (0.032)

Institutional Indicators
Common Law -0.214***
(0.056)
Rule of Law -0.001
(0.020)
Creditor Rights 0.015
(0.016)

Joint significance tests

Country dummies F (25,1878) 10.52*** 11.03*** 11.94*** -
Prob (F) (0.000) (0.000) (0.000) -
Time dummies F (9,1878) 10.90*** 11.46*** 7.22*** 7.83***
Prob (F) (0.000) (0.000) (0.000) (0.000)
Adj. R2 0.21 0.23 0.24 0.13
No. Obs 1916 1916 1916 1916

*
/ ** / *** Indicate significance levels of 10, 5 and 1 percent respectively.

32
 Table 7: Fixed Effects Regressions

Total sample G10 countries Non-G10 countries

Bank Indicators
EBTDA/Total Assets 0.017 0.112*** 0.114*** 0.067*** 0.067*** 0.071*** -0.025 0.155*** 0.161***
(0.014) (0.016) (0.016) (0.018) (0.021) (0.022) (0.024) (0.026) (0.026)
Negative Earnings Dummy -0.518*** -0.528*** 0.003 0.010 -1.068*** -1.083***
(0.048) (0.048) (0.06) (0.06) (0.079) (0.079)
Total Loans/Total Assets 0.015*** 0.014*** 0.013*** 0.016*** 0.016*** 0.016*** 0.010*** 0.009*** 0.008***
(0.001) (0.002) (0.001) (0.001) (0.001) (0.001) (0.003) (0.003) (0.003)
Growth Rate of Loans -0.012*** -0.012*** -0.010*** -0.010*** -0.010*** -0.009*** -0.016*** -0.016*** -0.014***
(0.001) (0.001) (0.001) (0.001) (0.001) (0.001) (0.001) (0.001) (0.001)

Macro Indicators
LN(Debt/GDP) -0.643*** -1.191*** -0.546***
(0.086) (0.191) (0.111)
LN(GDP per Capita) -2.913*** -6.472*** -2.604***
(0.392) (1.048) (0.520)

No Obs 5957 5957 5957 4041 4041 4041 1916 1916 1916
R2 0.12 0.14 0.14 0.14 0.14 0.14 0.14 0.23 0.25

Joint significance tests

Bank dummies F value 23.81*** 25.98*** 8.92*** 20.64*** 20.44*** 5.23*** 11.43*** 11.32*** 7.49***
Prob (F) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)