Loan-loss provisions and bank buffer-stock capital

McKenzie, George (1996) Loan-loss provisions and bank buffer-stock capital. Applied Financial Economics, 6 (3), 213-223. (doi:10.1080/096031096334231).

Record type: Article

Abstract

Two problems are identified in the treatment of loan-loss provisions under the Basle Accord as modified in 1991. It is suggested that a distinction should be made between expected and unexpected loan losses and that the former should be treated in the same way that identified losses are. That is, they should not be allowed to count as capital. However, capital should be maintained as a 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. This paper examines the implications for provisioning of (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. Critics will argue that the calculation of expected losses is a highly subjective activity. However, the timing of a decision to 'identify' a loss for balance sheet purposes and the level of provisioning against non-performing loans also involve highly subjective judgements. Attempts to calculate expected loan losses focus the attention of bank management on the factors which affect the creditworthiness of borrowers.

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