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.