Are Basel Capital Standards Pro-Cyclical? Some Empirical Evidence from India Author(s): Saibal Ghosh and D. M.

Nachane Reviewed work(s): Source: Economic and Political Weekly, Vol. 38, No. 8, Money, Banking and Finance (Feb. 2228, 2003), pp. 777-778+780-784 Published by: Economic and Political Weekly Stable URL: http://www.jstor.org/stable/4413248 . Accessed: 15/02/2012 05:35
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Are

Basel
Some

Capital

Standards Pro-cyclical?
from India

Empirical Evidence

The debate on bank capital regulation has in recent years devoted specific attention to the role that bank loan loss provisions play as a part of the overall minimumcapital regulatoryframework. The new Capital Accord is also attemptingto address provisioning practices within a broad capital regulatoryframework. This paper contributesto the debate by exploring the available evidence about bank loan loss provisioning in the Indiancontext. Using data on state-owned banksfor the period 1997-2002, we find that banks tend to delay provisioningfor bad loans until too late, possibly magnifying the inmpact the economic cycles on their income and capital. of
D SAIBAL GHOSH, M NACHANE

Introduction
risk-based is widely perceived-that tend minimum capitalrequirements to have a pro-cyclical effect on the economy[Borioet al 2001]. The deteriorationof the qualityof bank loan portfolios, especiallyin economicdownturns oftenincreases banks'riskexposure,and the therefore, levelof capital requirements, exactly when capitalbecomes more expensiveor simplyinaccessibleto weaker institutions. As observed by the BIS (2002: 123). are Business cycleexpansions oftensupin of ported increases the profitability by and financial institutions a greater willingto ness of theseinstitutions takeon risks and to compete aggressivelyfor new business....In downward the phaseof the can As cycletheprocess workin reverse. and declines confidence falls, profitability can from financial institutions retreat riskfor and taking seekgreater compensation to therisksthattheyareprepared take... This is especiallythe case if duringthe sheetof financontraction thebalance phase are cialinstitutions significantly impaired. The discussionon this topic has raged ever since the 1988 CapitalAccord was originallyinstitutedin G-10 economies andsubsequently, followingthe introduction of Basel-likeapproach most deby velopedandemergingeconomiesaround the world.On one side, it was recognised that risk exposuresneed to be explicitly mirrored the level of bank capital, if in is arbitrage to be avoidedand regulatory bankstability On pursued. theotherhand, thepotential exteralitiesof capital negative havebeen stressed,pointingto regulation thecontraction creditsupplythathigher of It
Economic and Political Weekly

may during capitalrequirements generate economic downturns. The debatehas becomemoreanimated in thelastcoupleof yearsas a consequence of the ongoingrevisionof the old Accord [BCBS 2001]. The presentpapercontributes to the ongoingdebateby focusing on a frequentlyignoredaspect of bank as capital:the role of loanloss provisions a componentof bankregulatory capital. are Thequestions addressed twofold: First, whatdoes empirical evidencesuggeston trendin loan loss provisioning Indian by state-owned banks?Second,whatarethe policy implications arising out of the empiricalevidence? In the lightof the foregoingdiscussion, as the rest of the paperis structured follows. Section II drawsfrom the current debate on banks' capital requirement. SectionIIIdiscussesthe role of loan loss banks' miniprovisions in determining mum solvency ratios. The international withrespect recognition proof to practice are blem loansandthe Indianexperience in two described the subsequent sections. SectionVI describesthe empirical procedure and the data. The findings of the in analysisare reported SectionVII. The sectionetches out the policy penultimate implications of the analysis. Finally, the concludingremarksare gatheredin Section IX.

beentwofold.Onone side,there primarily is a beliefthatsincein a downturn, specific provisions and write-offs increase, this wouldreducebanks'capitalanddiminish their appetitefor makingnew loans. A concern,espesecond, more generalised the ciallyunder newAccordhasbeenthat, as the condition borrowers of deteriorates an economicdownturn, during they will be downgraded bankswith the conseby has quencethatextra capital to be setaside, the exacerbating capitalshortpotentially The expression'capitalcrunch'was age. coinedin theearlyninetiesto characterise the simultaneous shortageof capitaland thecontraction the supplyof new loans in thataffected banks New England in during the early 1990s recession in the United States [Bernanke and Lown 1991, Peek and Rosengren1995]. A capital crunch could result in the reductionof total bank assets or alterless nately,in a shifttowards riskyassets, such as government bonds. A surveyby the Basel Committee of the evidence available for industralised economies concluded 'there someevidencethat that is bank capital pressures during cyclical downturns the US and in Japanmay in have limitedlendingin thoseperiodsand contributed economicweakness some in to macroeconomicsectors [BCBS 1999]. Recent empiricalevidence demonstrates thattheintroduction moreseverecapital of II regulation may have reducedbankcredit economies Bank Requirements supplyacrossseveralemerging Capital [Chiuriet al 2001]. andthe Economic Cycle Theconcern beenrecently has addressed The cyclical effects of bank capital by policymakers well. TheBaselComas matter of mittee on BankingSupervision(BCBS) havebeenthe subject regulation an extensive theoreticaland empirical had issued a Consultative Paperin 1999 literature. The concerns arising have delineating sound practices for loan
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it wherein setouttheprinciples accounting for recognition and measurement of loans. The Financial Stability impaired Forumhas raised the question whether of severalfeatures thenew capitalAccord presentlydiscussedby the BCBS could increasethe cyclical fluctuationsin the economy. In response, the BCBS has that confirmed risk-based capitalrequirements are inevitablypro-cyclical(more in capitalis required recessionsbecause creditrisk in banks'portfoliosincreases in cyclical downturns) and suggested thatthe cyclicity questionshould be adinstruments. dressedby meansof different At thetheoretical level, anexplicittreatof mentof theimpact capitalrequirements on thelevel of economicactivityhasbeen and by provided Holmstrom Tirole(1997) that withina framework offersa rationale for applyinglower solvency ratiosin recessions. Theirfindingsreveal that, in a worldwhereagents,both in the real and financial sector constrained, maybecapital market-driven solvency ratios are proexpancyclical,i e, theyarehigherduring sions and lower duringrecessions.More precisely,theyshowthata negativeshock to banks' capitalnegativelyimpactsthe level of economic activity and that the lowerlevel of investment generated the by capital crunch requires a reduction of market-determined solvency ratios. Dewartipontand Tirole (1994) also remarkthat the lack of discrimination and between idiosyncratic macroeconomic effects by shocks may have undesirable riskaffectingbankmanagers' negatively incentives.Bankmanagers would, taking bothfor idiosyncratic in fact,be punished shocksthatareundertheircontrolandfor shocks that are outside macroeconomic theircontrol. TheyconcludethattheBasel are standards 'excessivelytoughon bank managersin recessions'.

non-capitalbank liabilities.The sum of tier-I and tier-II capital representsthe of numerator the solvency ratio and deflated by the bank's total risk-weighted so needsto meet assets,thenumber arrived minimum requirements. Capiregulatory tal is of crucialimportance banksbeto actionis often causeprudential corrective basedon capitalperformance [Cotavarria et al 2000]. it Mathematically, can be demonstrated that a loan loss provisionsmanagement coherent with an increase of loan loss reservesin good times and a decreasein bad times reducesbank profit volatility of andthe probability a negativeshockto economic capital. Following Kim and Santomero(1993), considera bank that financeseachperiodt a one-period project of Re 1. Withprobability the project PH, is a successwithpayoff(l+rH)at timet+1 and with probability (1-pH), the project fails witha payoffof 0 at timet+1. Under if risk-neutrality,followsthattheexpected at return the project timet is 1 plusthe on risk-freerate, rf, or, + PH.(l+rH) (l-PH).O= (1+rf) (1) where, rH>>rf It follows thatthe required in case of rate success equals is andthedefaultpremium (rH-rf) equalto the Underrisk-neutrality, lendingrate on loanswouldequalrH.However,given the possibilityof default,it wouldnot be to of earnings rHin case appropriate report of success at t+1. To reflect the true of underlying profitability thebankattime t+1,thebankneedsto setasideitsexpected loss equalto the defaultpremium (rH-rf). This has the effect of smoothing reported bank earnings over time and reduces the possibilitythatthebankhasto eat into its capital in case a futureprojectfails (at time t+2,...). Moregenerally, bankscan smooththeir fromloan loss reservesif actual earnings losses exceed expected losses and by additional loss provision loan contributing to loan loss reservesif actuallosses are losses.Theadvantage lowerthanexpected is of incomesmoothing thatit reducesthe volatility of reportedbank profits and reducesthe possibilitythatthe bankmay eat into its capital.With perfectincome smoothing,earningsarenot (or, are less) affected thefluctuations creditlosses of by overthecycle. Thisis achievedwhenloan loss provisions for compensate the difference between realisedcredit losses and
rH - rf = (l+rf).[(l-PH])/pH] (3) rH = [l+rf)/pHI-1 (2)

averagecredit losses by takingpositive values during cyclical expansions and As negative values duringdownturns. a result,loan loss reserveswould increase in good times anddecreasein bad times. tested Severalpapershave empirically the hypothesisof income smoothingand havearrived different at results.Basedon data on individualUS banks,Greenwalt andSinkey(1988),Collinset al (1995)and Ahmedet al (1999) found a positiverelation between loan loss provisionsand bankearnings,while Beattyet al (1995) do not find evidenceof earnings smoothet Fernandez al (2002) ing.Morerecently, of banksfor usinga paneldataset Spanish theperiod1986-2000founda fairlyrobust betweenloan and significantrelationship loss provisionsand the businesscycle.

IV

Provisioning Requirements: Practice International

In manycountries, rulesforloanloss the losses do provisioning not aim to capture at an early stage, but ratherto consider 'objective'factorsthatcouldbe takeninto account. Somecountries principleprovide on basedrules,withonlygeneral guidance how to determine adequate provisioning. Thisapproach commonin theEuropean is Union (Table 1). In contrast, emerging marketsoften minimumprovisiondefine quantitative AmongnonG-10couning requirements. are tries, provisioning requirements usually defined in four or five categories, Brazil(nine)andMexico(seven) although employs more categories.

V
Provisioning Requirements in India
finanOne of the meansfor improving cial soundnessof a bankis by enhancing the provisioning of standards the bank.In the Indiancontext,it has beenfoundthat 'the cumulativeprovisionsagainst loan to losses of publicsectorbanksamounted a mere41.67 percentof theirgrossNPAs for the year ended March 31, 2001' 2002]. [Muniappan The changesin the provisioning norms the periodunderstudyis provided during in Table2. As observed,the provisioning norms for Indian banks are broadlyin consonancewith international pracbest tices.However,therehasbeenwidevariathe tion in maintaining provisionamong

III

LoanLoss Reservesand BanksMinimum Capital Requirements

minimum Current solvencyregulations termed refer of commonly toanotion capital whichresults fromthe capital', 'regulatory et and sumof tier-I tier-II (Berger al capital The majorityof tier-I capital is 1995]. and capital retained represented paid-in by earnings, while tier-II capital includes generalloanloss reservesanda varietyof bankliabilitiescharacterised a lower by degreeof senioritywith respectto other

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banks. Some of the banks in the public loan as sectorhad low provisioning against losses as 30 percent of theirgross NPAs and only five banks had provisions in excess of 50 percent of theirgrossNPAs [Muniappan2002]. A suggestion was madethat 'Indianbanksshould therefore levels to at least the improve provisioning NPAs[Muniappan theirgross 50percentof beenechoed 2002].Thesamehasrecently by the RBI (2002) wherein it observed that: In market-driven systems,the seeds of creditexcessesareoftensown in an upswing when boom conditionsprevail. However,once financial excesses are for there unwound, canbeatendency loans and of to go bad,attheexpense thelender In of thehealth thefinancial system. order credit of the tocounter benefits faster growth in a boom againstthe costs of volatile economic cycles once the movements that it reverse, is important banksarenot with balanced prudential only equipped or but norms, also haveforward-looking so a dynamic provisioning as to build-up in cushion goodtimesthatcan protective be drawndownin exigencies.Thereis, their to need therefore, forbanks improve full provisioning practices: provisioning assetsneedsto towards already impaired be a priority corporate goal.

and productsophistication customerorientation and comprise the bulk of the bankingsystem in India,2a studyof the SOBs suffices to draw broadinferences about the bankingsector as a whole. We hypothesize thata bankshows imprudentloan loss behaviour,susceptible effecton banks'capito havepro-cyclical tal,if one of thefollowingthreeconditions are met: (1) Loan loss provisionsare negatively associatedwith banks' earnings. (2) Loan loss provisionsare negatively relatedto real loan growth. (3) Loan loss provisionsare negatively relatedto real GDP growth. to Condition refers theincome-smooth(1) condition(2) captures ing hypothesis, misalignmentsin loan loss provisions, whilecondition denoteswhatmightbe (3) to referred as 'irrational exuberance'. The Chart1 displaysthe trendsin real real loangrowth, GDPgrowthandgrowth in loan loss provisionsby Indianstateowned banks over the sample period. Whileit masksthe differential provisioning levels among state-owned banks it owing to its aggregaterepresentation, the doescorroborate beliefthat,whenGDP growthis high andthereis a demandfor

loans, loan loss provisionstend to dip, in reflectingsome sort of exuberance an upswing. Static Loan Loss Provisioning To verify the natureof the relationship betweenbanks'provisioning earnings and and to test our hypothesesaboutthe determinants banks' provisioningdeciof the sions,we estimate followingequation: = + (LLP/A)i,t a + P1 (EBP/A)i,t P2 ALit + 3 AGDPt + N4 TDt + whereloanloss provision (LLP)overtotal bankassets (A) for banki at time t are a of function profitsbeforetaxandloanloss provisions(EBP) over total assets loan growthin realterms(AL) realgrowthin GDP (AGDP) at time t. Year control dummies to (TD)areintended catchtimespecific effects, such as trends in the stance.Thedependent variable regulatory of the regression (4) is the level of loan in lbss provisionsscaled by the one period lag of total assets. We employ lagged values of stock variables current and valuesof flow variables to avoid the potentialendogeneity For problem. example,loanloss provision
Vit + Ei,t

(4)

VI Data Methodology and

on In orderto testthe factorsimpinging we loanloss provisioning, employdataon banks 27 state-owned (SOBs)fortheperiod To 1997-2002.1 the extentthatSOBs are in of heterogeneous terms their sufficiently

Table 2: Provisioning Requirements: Indian Banking System for Provisioning

Standard assets

1996-97
-

1997-98 1998-99 1999-2000 2000-01

0.25 0.25

2001-02
0.25

assets Sub-standard Doubtful assets (securedportion) assets (unsecured Doubtful portion) Loss assets

10 20-50 100 100

10 20-50 100 100

10 20-50 100 100

10 20-50 100 100

10 20-50 100 100

10 20-50 100 100

Provisionsfor secured portionof a loan are 20 per cent if it is doubtfulupto 1 year, 30 per cent if it is for doubtful 1-3 years and 50 per cent beyond3 years.

Table 1: Loan Classification and Provisioning for Domestic Loans Country Loan Categories Pass Special Mention Provision Overdue (Per Cent) (M) Sub-standard Doubtful Loss Provision Overdue Provision Overdue Provision Overdue (Per Cent) (Per Cent) (Per Cent) (M) (M) (M)

G-10 Germany Italy Japan UK US Non G-10 Argentina Secured Unsecured Brazil Chile Czech Rep Repof Korea Mexico Singapore Spain

4 5 5 5 5 5 9 5 5 5 7 5 6

Upto 3

15 -

Upto 6

70 25 50 40-79 50 50

-100 6-12 3 or more Over6 50 100 80-100 100 100 100 100 Over12 3 or more Over36 -

1 1 1 0.5 0.5-1

3 5 5 0.5 -

-12 -25 0-5 1-3 2 Upto 3

5-39 20 20 Atleast 10 10

3-6 -

3 or more Atleast 50 3-6 25-100

M:months Source:WorldBank(2002).

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Chart 1: Loan Loss Provisioning, GDP Growthand Loan Growth

----. ', __,-____-____

35

--4-

2--25I
(D

-5

---

o-

-----)-

ac

-o
YCeMr

o
C\J

-o
C

o
\j

Year _GDP LNGR ----LLPGR

at time t correspond to provisions during the year t, while assets at t-1 correspond to the stock of bank assets at the beginning of the year t. Hence, (LLP/A)t is measured as LLPt/At_1. Our important explanatory variable is bank profit before taxes and provisions. We control for bank risk through loan growthandfor the economic cycle through real GDP growth. The real growth rate of bank loans is presumed to be positively associated with bank risk, given that rapid growth of bank lending is generally associated with lower monitoring efforts and a deteriorationin the quality of loan portfolios [BIS 2002]. A prudentbank should, therefore, show a positive association between the amount of loan loss provisions and the growth rate of its loan portfolio. We estimate model (4) using bank-specific random effects.

Dynamic Loan Loss Provisioning

While static models of loan loss provisioning capture certain basic tenets of provisioning practices by banks, a much richermodel is obtained when we consider a dynamic model of loan loss provisioning. Such a framework,would, in essence, capture the speed of adjustment of loan loss provisions to an equilibrium level. Towards this end, we specify a dynamic model of loan loss provision by introducing lags of dependent variable: (LLP/A)i,t = a( + Yi (LLP/A)i,t_-+ Y2 (LLP/A)i,t-2 + 1 (EBP/A)i,t + [2 ALi,t + f33AGDPt + 34 TDt + (5) vt + i.t The advantage of this formulation consists in a better approximation of the potential impact of stock variables on loan loss provisions at time t, captured through

lagged values. This reduces the potential problems related to omitted variable and makes it possible to focus on the effects of flow variables on loan loss provisioning. We include the first and the second lag to take into account changes in the speed of adjustmentbeyond the first year. The inclusion of lags of the dependent variable renders static panel estimation of (5) inconsistent. As a consequence, we resort to the Generalised Method of Moments (GMM) estimator in Arellano and Bond (1991) to obtain consistent estimates of the above model [see for instance, Easterly et al 1997, Loayza et al 1998]. Based on the above specifications, the hypothesis of prudentloan loss provisioning behaviour is rejected if one of the following three conditions is met: (a) the coefficient on (EBP/A) is negative; (2) the coefficient on loan growth is negative; and, (3) the coefficient is negative. If condition (1) holds, then the hypothesis of income smoothing is rejected. If condition (2) and/or (3) holds, then there is evidence that banks are not pursuing a pro-cyclical provisioning behaviour. Yearly data on the variables have been extracted from the RBI AznnualReport, Table 3: Regression Variables: Summary Statistics Report on Trendand Progress of Bankitng in india and Statistical Tables Relating to Variables Mean Std Devn Minimum Maximum Banks in India.

average rate of real loan growth equal to 11.34 per cent. Table 4 presents the correlation matrix of the regression variables. The correlations indicate a statistically significant correlation between loan loss provisions and each of the explanatory variables. The correlation between loan loss provisions and earnings before tax is around 20 per cent, suggesting that banks do exercise income smoothing on average. The correlation between loan loss provisions and loan growth is negative and around 20 per cent, suggesting lack of prudentbehaviour by the average bank. Finally, the correlation between loan loss provisions and GDP growth is also negative at around 12 per cent, suggesting an anti-business cyclical behaviour of bank's loan loss provisioning. Table 5 presents the basic random effects regression results for the model in (4). It is observed that there is a positive and significant relationship between the ratio of loan loss provisions and bank earnings (both scaled by the beginning of period stock of bank assets). These results are consistent with results for the US banking industry [Greenwalt and Sinkey 1988] and suggest that state-owned banks in India have followed an income-smoothing pattern,on average. The real loan growth rate, on contrary, has a negative coefficient. Banks appearto have increased the amount of provisions during periods of positive profits, but at the same time, they have been less prudent during periods of rapid credit growth. This effect of loan growth on provisioning is significant as well, but somewhat less strong than the effect of a change in earnings. We also find a negative relationship between GDP growth and loan loss provisions, suggesting thatbanks do not make sufficient provisions before

VII Estimation and Results

Table 3 provides some descriptive statistics about the variables in the estimation sample. At a ratio of lagged total assets, loan loss provisions are on average equal to 0.74 per cent (with a standarddeviation of 0.39 per cent), the ratio of earnings before taxes and provisions to lagged total assets equals 1.45 per cent and the

LLP EBP AL AGDP

0.743 0.391 1.449 0.702 11.339 8.519 5.683 1.095

0.001 -1.314 -16.580 4.000

2.728 3.306 37.893 7.300

Table 4: Correlation Matrix among Explanatory Variables Variables

LLP

LLP
1.000

EBP

LNGR GLPGR

EBP AL AGDP

0.199 -0.202 -0.117

1.000 0.418 1.000 -0.080 -0.155

1.000

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economic recessions and this effect is The elasstatistically significant. long-run of (LLP/A)relativeto GDPgrowth, ticity calculated the sampleaverage,is 0.19. at The resultslend credenceto the findings of Cavallo and Majnoni(2001), who in for of theirstudy loanlossprovisions 1,176 banks (372 of which from non G-10 in countries)3 36 countries(includingthe observed G-10countries) that,on average, banks nonG-10economiestendto make in too littleprovisionin good times andare, to therefore, compelled increase provisions in bad times. of To allow for an asymmetric pattern loan loss provisions during periods of we positiveandnegativeearnings, interact the earnings variable (EBP/A) with a that dummyvariable takesvalue 1, when are earnings negativeandzero, otherwise (Column3 in Table 5). This technique to whether banksdig into attempts capture their capital to make provisions in bad times. The findings reveal that during cyclicaldownswings,bankseat into their for capitalto makeprovisions loanlosses, and therefore,on average,banks do not provisionenough during good times to cover losses duringbad times. The loan growthand GDP growthvariableshave the same signs and theirmagnitudes arebroadlythe same as earlier.The results indicatethatbanksmakestatistically sigwhentheyincur nificant higher provisions a losses4thanwhentheygenerate positive and level of incomebeforeprovisions tax. Theaverage association betweennegative earnings and provisioningis 0.71 (the absolute valueof thesumof thecoefficient on earningsand the coefficient on the interactionterm between earnings and earningsdummyvariable). Table 6 presentsthe basic regression resultsof the dynamicmodel in (5). The results similarto obtained Table4, are that in where the specificationdid not include variable. Again,we lags of the dependent find a positive associationbetween the ratio of loan loss provisions and bank the earnings, suggesting averagepresence of income-smoothing. together with a negative association between loan which growthandloanloss provisioning, thatthe lack of considerations of signals the real businesscycle effects on credit quality. While this methodimplies the loss of certain number observations to the of due inclusionof lagged dependentvariables, the signs of the independent variablesare with a distinctimprovement in unaltered,

their magnitudes, providinga fair testiof monyof the robustness the results.The coefficienton thefirstlagof thedependent variableis fairly high (with a point estimateof 0.94) andstatistically significant, suggestingmoderate speedof adjustment by banksto the optimalpathof provisionhorizon. ing over a multi-year We again add an interaction term betweenthe earnings variable a dummy and variable takesvalue 1, whenearnings that arenegativeandzeroelsewhere,to allow for an asymmetricpatternof loan loss provisionsduringperiodsof positiveand negative earnings. Again, the findings suggest banks make statisticallysignificant higher provisionswhen they incur losses thanwhenthey generate positive a level of incomebeforeprovisions tax. and This corroboratesthe fact that during cyclicaldownswings,banksdig intotheir capitalbase to make provisionsfor loan losses andtherefore, average, on banksdo not provisionenough in good times to cover losses when the situationbecomes adverse.

VIII

PolicyImplications andObservations
There are several policy implications thatariseout of the aforesaid study.First, evidencesuggeststhatstate-owned banks tend to delay provisioningfor impaired loansuntilit is too late.Thiswouldsuggest

a need for policy incentivesto encourage banksto make sufficientprovisioning to take care of exigencies. Keepingthis in mind, the Union Budget 2002-03 raised the allowance for deduction by banks against provisions made for bad and doubtful debts from 5 per cent of their totalincome to 7.5 per cent. This would provide additionalfiscal relief offered to banks to strengthen their financial position. Second,the analysissuggeststhe need for distinguishing between'specific' and 'general'loan loss provisions. According to accountingpractices,'general'provisions referto 'ex ante'provisions are and relatedto futureuncertain events. 'Specific' provisions,on the otherhand, are 'ex post' in nature,in that they refer to certain events(suchas past-due payments or otherdefaultlike events) for which a can specific documentation be produced. Forinstance,provisions triggered past by due payments(one of the defaultevents consideredby the Basel Committeeon Banking Supervision) could be consideredas 'specific'provision. Provisions which are,instead,required all loans, for independentlyfrom the presence of a default event, can be considered of a 'general' nature.Following the general consensus, economic capital should be tailoredto deal with unexpectedlosses andloan loss reserves should instead, buffertheexpectedcomponent the loss of distribution.

Table 5: Test of Income-Smoothing Variable (1) EBP/Asset Negative Earning Dummy*(EBP/Asset) LoanGrowth GDP Growth TD Hausmantest [p-value] No of bank-year observations WholeSample (2) 0.118 (2.19)* -0.012 (-3.87)** -0.025 (-1.93)*** 0.029 (1.81)*** [0.020] 162 NegativeEarningsDummy (3) 0.272 (5.13)* -0.989 (-4.93)* -0.013 (-4.19)* -0.031 (-1.98)*** 0.032 (1.92)*** [0.018] 162

Figuresin bracketsindicatet-statistics;* **and ***indicate significanceat 1, 5 and 10 per cent. Table 6: Test of Income Smoothing: GMM Estimates Variable (1) First of (LLP/A) lag Second lag of (LLP/A) EBP/Asset Negativeearnings dummy*(EBP/asset) Loangrowth GDPgrowth TD Sargan'stest (Chi-square) Test forautocorrelation order2 [p-value] of No of bank-year observations WholeSample (2) 0.937 (15.01)* -0.070 (-1.19) 0.013 (1.92)*** -0.0004 (-2.47)* -0.006 (-2.40)* 0.005(1.92)*** 22.67 0.049 108 NegativeEarnings Dummy (3) 0.922 (14.76)* -0.062 (-1.05) 0.028 (1.81)*** -0.894 (-2.10)** -0.0003 (-2.46)* -0.007 (-1.91)*** 0.005(1.85)*** 18.42 0.042 108

Figuresin bracketsindicatet-statistics;, **and ***indicate significanceat 1, 5 and 10 per cent.

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Chart 2: Timetable of Events Resulting in Provisioning Lending environment Debtor's deterioration Debtor'ssituation deterioration Past Due Impairment Loss

Time

Dynamic Provisioning DynamicProvisioning

GeneralProvisioning General Provisioning

Early Specific EarlySpecific Provisioning Provisioning

Specific SpecificProvisioning Provisioning provisions. The econometric evidence suggests that state-owned banks, on average, tend to postpone provisioning when faced with favourablecyclical and income conditions, until negative conditions set in. The study then examines certain policy issues that arise from the aforesaid analysis. While it is becoming increasingly clear that more explicit recognition needs to be paid to the problems associated with provisioning policies, in practice, however, the solution is not easy to envision as a result of complicated interaction of accounting, fiscal and prudential requirements. It is important that systems have a forward-looking focus, considering factors such as borrowerrepayment capacity and economic conditions, as well as ex post factors such as interest past due. Looking forward, finding ways of dealing with cycles through provisioning practices is likely to remain an importantchallenge for bank supervisors and other policy-makers. B3 Addressfor correspondence: nachane hotmail.com @

Third,thougha minimumrequirement for standard loans (which amountsto a can de factogeneral provision) be considof ereda minimum requirement a forwardceteris paribus,it might lookingsystem, be desirableto set aside more resources and of during periods economic loangrowth This patternof than duringdownturns. general provisions, labelled 'dynamic havebeenadvocated BIS by provisioning' (2002), which observes that "...bankers shouldaccumulate capitalin good times to runit downin bad.Weretheyto do so, fearsof heightened financial pro-cyclicity The wouldbe muchreduced". fundamentalprinciple such underpinning provisionare ing is thatprovisions set againstloans in outstanding each accountingtime period in line with an estimateof long-run expected loss [Jackson 2002]. Such a system has been introuucedin several economies like Portugaland Denmark [Bank of England2000] and forcefully advocated by the French Commission Bancaire Bancaire 2001].In [Commission fact, conventional provisioning practices follow a timetable linkedto a forecastof a recognised to default, belonging theright handside of the time line (Chart 2). fromthesupervisory Fourth, standpoint, authorities are faced with a trade-off between (belatedly)enforcing stringent banks' standards, capital thereby depleting and a capital adopting policyof regulatory underwhich banksare perforbearance, mitted mask their loan to prospective losses in the hope thatthe passageof time will theirbalancesheets. enablethemto repair Inthiscontext,Beattie al (1995)observe et that such forbearancewas particularly evidentduring handling theS andL the of crisisof the 1980s by the US authorities' and the Norwegianbankingcrisis of the early 1990s.
Economic and Political Weekly

One way of partly alleviating these to is banks concerns forsupervisors require to createa provisionat the origination of every loan. However, this approachis becauseit impliesthatloans problematic are systematically failingto underpriced, of recognisethatthenature anyunderpricing is likely to changeover the courseof a creditor businesscycle. This approach could, however, be justified if it were agreed that financial statementsshould reflect more prudenceand conservatism from thanmightbewarranted aninvestor's et al, 2001]. perspective[Borio Another, quiteradical, perhaps approach for wouldbe to decoupleprovisions prudential purposesfrom those set by acIn supercountingauthorities. particular, visors could supplement capitalrequirements with a prudentialprovisioning One requirement. wayof doingthiswould be to implementa system along similar in lines to thatrecentlyintroduced Spain. In this situation, banks have to make a fromthetimeof granting loan provision which runsin parallelwith revenuesand aretherefore distributed the through cycle for a better mappingbetween allowing income and costs in the profit and loss account [Poveda 2000, Bank of Spain 2001]. One possible advantageof this is banksto approach thatit wouldrequire holdlarger buffersagainstadverse capital events in good times.

Notes
[The views expressedin the paperarethe authors' personal views.] 1 As part of additional disclosures, banks have been mandated to disclose provisions towards loan losses from the year 1996-97 onwards in the 'Notes on Accounts' in the balance sheet. 2 As at end-March1997, SOBs accountedfor 80 per cent, respectively, of the total assets of ScheduledCommercial Banks.Thisfigurestood at 76 per cent at end-March2002. 3 Indiawas not includedin the nonG-10 countries of the sample. 4 Note that negative EBP times the negative regression coefficient of the integratedterm

IX

Remarks Concluding
Theissueof provisioning loanlosses for has recently attractedthe attention of and policy-makers alike [BIS regulators 2001, 2002]. Using data on state-owned banksfor theperiod1997-2002,thepaper examines the cyclicality of loan loss

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Macroeconomic Linkages', IMF Working Bank of England, December, 128-36. Kim, D, and A Santomero(1993): 'Forecasting Paper No 195 (www.imf.org). Dewartipont,M andJ Tirole (1994): ThePrudenRequired Loan Loss Reserves', Journal of tial Regulation of Banks, MIT Press, Economics and Business, 45, 315-29. and Cambridge. Loayza,N, KSchmidt-Hebbel L Serven(1998): 'What Drives Private Saving Around the Ahmed,A, C TakedaandS Thomas(1999): 'Bank Easterly,W, N LoayzaandP Montiel(1997): 'Has Latin-America'sPost Reform Growth Been Loan Loss Provisions: A Re-examinationof World?', (www.worldbank.org). Capital Management,EarningsManagement Disappointing?', Journal of International Muniappan, G P (2002): 'Indian Banking: Economics, 43, 287-312. and SignalingEffects', Journalof Accounting ParadigmShift-A RegulatoryPointof View', Fernandezde Lis, S, J. M Pages and J Saurina and Economics, 28, 1-25. Speech Delivered at the Bank Economists Conference, Kolkata. (2002): 'Credit Growth, Problem Loans and Arellano,M and S Bond (1991): 'Some Tests of CreditRisk Provisioningin Spain', BIS Paper Peek, J andE Rosengren(1995): 'CapitalCrunch: Specification for Panel Data: Monte Carlo No 1, BIS: Basel. Neithera BorrowerNot a LenderBe', Journal Evidence and an Applicationto Employment of Money, Credit and Banking, 27, 625-38. Equation', Review of Economic Studies, 58, Greenwalt,M B andJ Sinkey (1988): 'BankLoan Loss Provisions and the Income Smoothing Poveda, R (2000): 'Reform of the System of 277-97. BankforInternational Settlements(2001): Aznnual Hypothesis:An EmpiricalAnalysis', Journal InsolvencyProvisions',Bankof Spain,January 2001. of Financial Services Research, 1, 301-18. (www.bde.es). Report, - (2002): Annual Report, 2002. Holmstrom, B and J Tirole (1997): 'Financial ReserveBankof India(2002): TrendandProgress LoanableFunds and the Real Intermediation, Bank of England (2000): 'Financial Stability: of Banking in India, RBI: Mumbai. Journalof Economics,112, World Bank (2002): 'Bank Loan Classification Issues and Conjecture', Financial Stability Sector', Quarterly 655-91. and Provisioning Practices in Selected Review, December. Issues Bank of Spain (2001): 'Asset Price Bubbles: Jackson,P (2002): 'DynamicProvisioning: Countries',Finance DevelopingandEmerging andApplications',FinancialStabilityReview, Forum, June. Implications for Monetary, Regulatory and International Policies', speech by governorat Federal Reserve Bank of Chicago. Basel Committeeon BankingSupervision(1999): Sound Policies for Loan Accounting, Credit Risk Disclosure and Related Matters, BIS: Basel. - (2001): The New Basel Capital Accord: ConsultativeDocument, BIS: Basel. Beattie, V A, P D Casson R Dale, G McKenzie, C Sutcliffe and M J Turner (1995): Banks and Bad Debts: Accountingfor Loan Losses in International Banking, John Wiley, (Only women candidates can apply) New York. withthe (CYSD)is a leadingautonomousdevelopmentorganisation working towardsthe goal of people centereddevelopment. organisation's The Beatty, A, S Chamberlinand J Magliolo (1995): deprived core compatencylies in developmentof deprivedthrough action 'ManagingFinancialReportsof Commercial participatory and research. CYSDis lookingto recruit motivated Research, 33, a Banks', Journal of Accounctintg Social Researcherin its 231-62. Policy Research and Advocacy Centre (CEPRA). Berger, A N, R Herring and G Szego (1995): Job responsibility: Independentlydesign / carry out policy research on 'The Role of Capital in Financial Institudevelopmentalissues using qualitativeand quantitativeresearch tools & tions', Journal of Banking and Finance, statisticsand PRA. Thejob involvesleadinga groupof techniquesincluding 19, 393-430. researchers,steeringteamworkforfieldresearchin remoteareas, monitoring Bernanke,B andC Lown (1991): 'CreditCrunch', workof researchers; of evaluating reports&finalisation reports,writing reports. Brookings Paper on Economic Activity, 2, to Ability design and facilitate advocacy effortfromgrass root to policy level 205-47. & lobbying. L4ase with Research Institutions, NGOs and the Govt. for Borio, C, C Furfine and P Lowe (2001): 'To social development. empoweringthe poor and strenthening Provisionor Not to Provision', BIS Quarterly Essential Skills & Experience Review (Septe'mber), BIS: Basel. of Understanding Micro/ Macroissues such as poverty, rurallivelihood, Cavallo, M and G Majnoni (2001): 'Do Banks local governance, environment,gender, globalisation, economic reforms, Provisions for Bad Loans in Good Times? role of civil society. Knowledge of computer is desirable. 8 - 10 years of EmpiricalEvidence and Policy Implications', skills including minimum a experience withexcellent writtencommunication The IFCAI Journal of Applied Finance, of five (5) years in the fieldof social research are essential. Shouldhave a 7, 55-79. Masterdegree or higher (M. Phil, Ph. D) in Social Science and be aged Chiuri,M C, G Ferriand G Majnoni(2001): 'The between 35 - 45. Macroeconomic Impact of Capital Requirementsin EmergingEconomies:Past Evidence withskill, experience and qualification. Salary: Commensurate to Assess the Future', World Bank Policy Interested candidates may send updated curriculum vitae, with a writeResearch Working Paper No 2605. up (not exceeding 1000 words) on the topic "Structural causes for Collins, J. D Shackelfordand J Wahlen (1995): poverty in Orissa" to the following address within 10 days of publication 'Bank Differences in the Coordination of of this advertisement: Regulatory Capital, Earnings and Taxes', Journal of AccountingResearch, 33, 263-92. HRD OFFICER Commission Bancaire (2001): 'From Expected Centre for Youth & Social Development Loss to Dynamic Provisioning', July E-1, InstitutionalArea, P.O.- RRL,Bhubneswar-751013 (newrisk.ifci.ch). E-mail : cysdbbsr@sancharnet.in / cysdbbsr@vsnl.net L, C Dziobek, A Kanayaand I Song Cotavarria, Fax : 0674 - 2301226 , web site: www.cysd.org (2000): 'Loan Review, Provisioning and

(negativeearningsdummy*EBP) implies a on positiveeffect (increase) provisions.

References

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