Discretionary loan loss provisions and market discipline

Using a panel of 375 American universal commercial banks from 2008 to 2017, we provide empirical evidence that discretionary loan loss provisions increase when market discipline -- proxied by deposit rates -- strengthens. In particular, least-capitalized banks increase more their discretionary loan loss provisions following an increase in deposit rates than other banks do. Loan loss provisions can thus act as a substitute for capital to respond to market discipline. This result partly qualifies the enthusiasm raised by the implementation of forward-looking provisioning models. These models indeed grant great discretion to banks in the setting of loan loss provisions since the valuation method underlying them is subject to uncertainty. In this perspective, regulators should make sure that the implementation of forward-looking provisioning models is not done in a way that would encourage banks to substitute provisions for capital, which would prove detrimental to market discipline.