Do Dynamic Provisions Enhance Bank Solvency and Reduce Credit Procyclicality? A Study of the Chilean Banking System. By Jorge A. Chan-Lau
IMF Working Paper No. 12/124
http://www.imf.org/external/pubs/cat/longres.aspx?sk=25912.0
Summary: Dynamic provisions could help to enhance the solvency of individual banks and reduce procyclicality. Accomplishing these objectives depends on country-specific features of the banking system, business practices, and the calibration of the dynamic provisions scheme. In the case of Chile, a simulation analysis suggests Spanish dynamic provisions would improve banks' resilience to adverse shocks but would not reduce procyclicality. To address the latter, other countercyclical measures should be considered.
Excerpts
Introduction
It has long been acknowledged that procyclicality could pose risks to financial stability as noted by the academic and policy discussion centered on Basel II, accounting practices, and financial globalization. Recently, much attention has been focused on regulatory dynamic provisions (or statistical provisions). Under dynamic provisions, as banks build up their loan portfolio during an economic expansion, they should set aside provisions against future losses.
The use of dynamic provisions raises two questions bearing on financial stability. First, do dynamic provisions reduce insolvency risk? Second, do dynamic provisions reduce procyclicality? In theory the answer is yes to both questions. Provided loss estimates are roughly accurate, bank solvency is enhanced since buffers are built in advance ahead of the realization of large losses. Regulatory dynamic provisions could also discourage too rapid credit growth during the expansionary phase of the cycle, as it helps preventing a relaxation of provisioning practices.
However, when real data is brought to bear on the questions above the answers could diverge from what theory implies. This paper attempts to answer these questions in the specific case of Chile. It finds that the adoption of dynamic provisions could help to enhance bank solvency but it would not help to reduce procyclicality. The successful implementation of dynamic provisions, however, requires a careful calibration to match or exceed current provisioning practices, and it is worth noting that reliance on past data could lead to a false sense of security as loan losses are fat-tail events. Finally, since dynamic provisions may not be sufficient to counter procyclicality alternative measures should be considered, such as the proposed countercyclical capital buffers in Basel III and the countercyclical provision rule Peru implemented in 2008.
Conclusions
At the policy level, the case for regulatory dynamic provisions have been advanced on the grounds that they help reducing the risk of bank insolvency and dampening credit procyclicality. In the case of the Chile the data appears to partly validate these claims.
A simulation analysis suggests that under the Spanish dynamic provisions rule provision buffers against losses would be higher compared to those accumulated under current practices. The analysis also suggests that calibration based on historical data may not be adequate to deal with the presence of fat-tails in realized loan losses. Implementing dynamic provisions, therefore, requires a careful calibration of the regulatory model and stress testing loan-loss internal models.
Dynamic provision rules appear not to dampen procyclicality in Chile. Results from a VECM analysis indicate that the credit cycle does not respond to the level of or changes in aggregate provisions. In light of this result, it may be worth exploring other measures to address procyclicality. Two examples of these measures include countercyclical capital requirements, as proposed by the Basel Committee on Banking Supervision (2010a and b), or the countercyclical provision rule introduced in Peru in 2008. The Basel countercyclical capital requirements suggest that the build up and release of additional capital buffers should be conditioned on deviations of credit to GDP ratio from its long-run trend. The Peruvian rule, contrary to standard dynamic provision rules, requires banks to accumulate countercyclical provisions when GDP growth exceeds potential. Both measures, by tying up capital or provision accumulations to cyclical indicators, could be more effective for reducing procyclicality.