Loan-loss provisions and bank buffer-stock capital

McKenzie, George (1994) Loan-loss provisions and bank buffer-stock capital (Discussion Papers in Accounting and Management Science, 94-78) Southampton, UK. University of Southampton

Abstract

In principle, bank capital serves two functions. It represents i) the value of shareholder equity and ii) the value of the buffer stock available to absorb unexpected losses. The calculation of expected loan losses and the provisioning to cover these losses enables a clearer picture of the economic structure of bank balance sheets. In this paper, it is argued that such calculations should take into account i) the implicit subsidy enjoyed by borrowers in the form of limited liability and ii) the expected costs of administering insolvency in the event of borrower default. An expectation represents the most likely outcome. Hence there is a case that expected losses should be treated in exactly the same manner as losses which have already been identified. That is, provisioning against such losses should not be included in capital. However, provisions for unexpected losses should be included in capital. The major policy implication is that the timing of provisioning will be brought forward and the value of bank capital will be less than currently recorded using historical value accounting

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