01 May 2012

IMF Working Paper: 'Do Dynamic Provisions Enhance Bank Solvency and Reduce Credit Procyclicality? A Study of the Chilean Banking System'

Dynamic provisions could help to enhance the solvency of individual banks and reduce procyclicality. Accomplishing these objectives depends on country-specific features of the banking system, business practices, and the calibration of the dynamic provisions scheme.

At the policy level, the case for regulatory dynamic provisions has been advanced on the grounds that they help reducing the risk of bank insolvency and dampening credit procyclicality. In the case of Chile, the data appears partly to validate these claims.

A simulation analysis suggests that under the Spanish dynamic provisions rule provision buffers against losses would be higher compared to those accumulated under current practices. The analysis also suggests that calibration based on historical data may not be adequate to deal with the presence of fat-tails in realised loan losses. Implementing dynamic provisions, therefore, requires a careful calibration of the regulatory model and stress testing loan-loss internal models.

Dynamic provision rules appear not to dampen procyclicality in Chile. Results from a VECM analysis indicate that the credit cycle does not respond to the level of or changes in aggregate provisions. In light of this result, it may be worth exploring other measures to address procyclicality. Two examples of these measures include countercyclical capital requirements, as proposed by the Basel Committee on Banking Supervision (2010a and b), or the countercyclical provision rule introduced in Peru in 2008. The Basel countercyclical capital requirements suggest that the build-up and release of additional capital buffers should be conditioned on deviations of credit to GDP ratio from its long-run trend. The Peruvian rule, contrary to standard dynamic provision rules, requires banks to accumulate countercyclical provisions when GDP growth exceeds potential. Both measures, by tying up capital or provision accumulations to cyclical indicators, could be more effective for reducing procyclicality.

Full Working Paper

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