Dynamic Provisioning: results of an initial feasibility study for Croatia

1. Dynamic Provisioning: results of an initial feasibility study for Croatia Evan Kraft Director, Research Department Croatian National Bank* *The views expressed in this presentation are the author’s and not necessarily those of the Croatian National Bank.

2. Why dynamic provisioning? • Bank lending is procyclical • Provisioning is believed to be a cause of lending procyclicality • Provisioning that looked at the borrower “over-the-cycle” would decrease fluctuations in bank profits and lending, and help stabilize the economy

3. What determines provisions? • Research suggests that provisions • Increase as bank profits increase (“income-smoothing”) • Decrease as GDP falls • Decrease as loan growth increases (over-optimism)

4. Economists vs. Accountants: probable vs. expected losses • Current provisioning practice is backward-looking, based on recognition of events that have already occurred • Accounting standards support this partly because it decreases discretion and gives a good picture of the bank at a moment of time • Economists feel that this approach fails to recognize future losses that are sure to happen but we don’t know exactly when (i.e. during the next recession)

5. Provisioning during a recession is not fun • Harder to raise capital during a recession • Lower profits or even losses make it painful to create provisions • Increased provisions are usually seen by markets as a sign of problems and lead to further share price declines

6. Dynamic provisioning in Spain • New element: the statistical provision • A new type of general provision • Statistical provision based on expected losses for 6 categories of assets • Provision rates range from 0.1% (loans to firms with grade “A” long-term debt ratings) to 1.5% (current account overdrafts and credit overdrafts)

7. The Spanish system • The basis for the statistical provision is the sum of the provisions on each of the six asset categories • The statistical provision itself is the difference between the bank’s provisions and the standard basis • Tp = Sp + Gp + St where • Tp is total provisions • Sp is specific provisions • Gp is general provisions • St is the statistical provision

8. The statistical provision • The statistical provision is thus calculated as: • St = (w1*a1 + w2*a2 +….w6*a6)- (Sp + Gp) • Where w1 is the risk weight of asset class 1 and a1 is the amount of asset class one in the balance sheet. • Note that, in good times, Sp and Gp will be below their long-term averages, and St will then be positive. That is, banks have to form general provisions in good times • Similarly, in bad times, banks get to decrease their statistical provisions—money is released.

9. How the statistical provision “flattens” provisions

10. Some things to note • The loss probabilities for different asset classes are based on 16 years worth of data (two business cycles). • The Spanish system assumes that losses in the next business cycle will be the same on average as in the last business cycle. • The Spanish system seems to be incompatible with IAS 39.

11. Can Dynamic provisioning work in Croatia? • Provisioning does seem to be cyclical…

12. Dynamic provisioning in Croatia • But some banks do have irregular provisioning time profiles

13. A first try • simulation 1: total provision = actual + 0.75 x (4.78 - actual) • (4.78 is the average for the whole banking system over the whole time period studied) • simulation 2: total provision = actual + 0.75 x (bank's average Q4 96 to Q2 03 – actual)

14. A look at the first try • Actual and simulated provisions for average of 35 banks

15. Large Bank 1

16. Large Bank 2

17. Large Bank 3

18. Large Bank 2 Effect on profits

19. A new approach • Idea: try to estimate how rapidly the average provision is falling over time, controlling for the business cycle • Result: provisioning falling 0,06 percentage points per year

20. Another try • simulation 3: total provisions= bank fixed effect - 0,061 time • simulation 4: total provisions= actual - 0,061 time - 2

21. What it looks like • Average for all banks

22. Is it adequate? • Requires confidence that future decreases in provisioning will follow at the same pace as past decreases • Produces negative overall provisions for some banks in some quarters • Not very simple and probably not too robust

23. Concluding thoughts • Dynamic provisioning seems attractive as a way to decrease financial instability • But it is easiest to implement in stable markets with long data series and stable provisioning levels • One can either be patient and wait for more data or look at other ways to achieve the same goals.