Bank risks, provisioning and the business cycle: a panel analysis on European intermediaries

Few works were interested in the procyclical character of the provisioning policy. However, the accounting practices as regards provisioning of the loans losses adopted by banks fluctuate with the business cycle and can reinforce financial instability. The objective of this study is to examine whether and to what extent provisioning policy are procyclical. We focus on the interaction between business cycle and provisioning policy (loan loss reserves and loan loss provisions) consistent with the Basel Accord of 1988 which made loan loss reserves no longer part of Tier I capital in the numerator of the capital adequacy ratio. An empirical model on panel data is then adapted on European banks from 1992 to 2004. In this model we consider two types of provisioning policy determinants: loan loss provisions and loan loss reserves. We identify banks with different strategies and different characteristics based on the ratio of non interest income in total revenue. We find that large banks tend to hold less risk. They establish fewer reserves than small banks. However, our results provide that functional diversification have no impact on provisioning policy. We also find that risk weighted assets reduce the volatility of the provisioning policy (loan loss provisions and loan loss reserves) during the cycle. The findings of our research are consistent with the empirical work of Bikker and Hu (2002), Laeven and Majnoni (2003), of Bikker and Metzemakers (2005) who show that banks more fund loans losses in period of economic downturn than in period of economic upturn for a whole of the OECD countries.