Bank capital management: an examination of loan loss provisions under regulatory pressure : an empirical study of the Nordic banking sector
Abstract
We study whether and how capital regulation affects banks’ loan loss provisions. Using
handpicked data on 46 Nordic banks, we find that banks use discretion to reduce loan loss
provisions for regulatory capital management purposes. Exercising discretion to reduce
provisions shifts capital from the expected loss buffer to the unexpected loss buffer at the
expense of banks’ overall ability to absorb loan losses. Controlling for non-discretionary
determinants of loan loss provisions, we find that banks reduce provisions when an increase
in capital requirements puts pressure on eligible capital for regulatory purposes. Additionally,
we find that banks’ regulatory capital position influences provisioning behavior. We show
that a stronger regulatory capital position coming into the year yields higher levels of loan
loss provisions, while an improvement in regulatory capital position during the year
constitutes a reduction in loan loss provisions. When studying SIFI-banks and IRB-banks, we
find no evidence indicating that newly enacted regulations are effective in limiting
discretionary provisions for regulatory purposes. Our analyses indicate that banks exercise
discretionary provisioning behavior when circumventing regulatory capital requirements.