What drives heterogeneity of procyclicality of loan loss provisions in the EU?

This paper documents a large cross-bank and cross-country variation in the relationship between loan loss provisions and the business cycle and explores bank management specific, bank-activity specific and country specific (institutional and regulatory) features that explain this diversity in the European Union. Our results indicate that LLP in large, publicly traded and commercial banks, as well as in banks reporting in consolidated statements’ format, are more procyclical. Better investor protection and more restrictive bank regulations reduce the procyclicality of LLP. Additional evidence shows that moral hazard resulting from deposit insurance renders LLP more procyclical. We do not find support for the view that better quality of market monitoring mitigates the risk-taking behavior of banks. Our findings clearly indicate the empirical importance of earnings management for LLP procyclicality. Sensitivity of LLP to the business cycle seems to be limited in the case of banks which engage in more income smoothing and which apply prudent credit risk management.