Loan/Loss Provisioning in Emerging Europe: Precautionary or Pro-Cyclical?

The recent global financial crisis has generated considerable interest in reviewing the regulatory environment surrounding the banking sectors in most countries and proposals for changes designed to avoid such a severe outcome in the future. In this paper, we consider a particular aspect relevant to bank regulation, namely, the cyclicality of loan loss provisioning, in a region of emerging market economies. All eleven of the countries in our sample are currently new members of the European Union, the first group entering 2004 and the last country joining in 2013. Our time period from 1997 to 2010 covers roughly one and a half business cycles, starting with the impact of the Russian financial crisis and followed by a rapid growth of bank credit prior to the included global financial crisis. We find that the determinants of loan loss provisioning by banks in the region are similar to those found in the literature for other countries both developed and developing ones. We find evidence on income smoothing through provisioning and capital management by substitution. Unlike the results in much of the literature, we do not find statistically significant evidence of bank-specific pro-cyclicality, i.e., a strong positive relationship between provisioning and individual bank loan growth. However, we do find strong and robust evidence of macroeconomic pro-cyclicality, i.e., a strong positive relationship between provisioning and country GDP growth. Based on the innovative policy of dynamic (statistical) provisioning instrument adopted by Spanish regulators in 2000 to smooth provisioning over the business cycle, we draw implications for regulatory design specific to this region in which financial sectors are bank-centric and financial deepening is occurring.