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The higher provisioning procyclicality in the euro area is partly caused by an already higher loan loss procyclicality of euro area banks before their respective countries of location adopted the euro. In addition, the higher provisioning procyclicality in the euro area reflects the more negative growth experience of euro area countries during the global financial crisis, as the relation between GDP growth and provisioning is stronger during economic downturns.
In addition, there is considerable heterogeneity in provisioning procyclicality among euro area banks. In particular, provisioning is more procyclical at bigger banks, which could reflect that bigger banks are willing to take on more business-cycle related risks to their capitalization due to their too-big-to-fail status. Similarly, banks that are directly supervised by the European Central Bank (ECB), which tend to be larger, display more procyclical provisioning patterns. Furthermore, provisioning is more procyclical at better capitalized banks, which could reflect that better capitalized banks can better sustain the risks to capital inherent in provisioning procyclicality. Consistent with this, provisioning is more procyclical in countries with more stringent capital regulations.
Loan loss provisioning is the main driver of the cyclicality of bank capitalization in the euro area, as the sensitivity of provisioning to GDP growth in the euro area can explain about two thirds of the variation of bank capitalization over the business cycle. In addition, authors show that banks with more procyclical provisioning also display more procyclical lending over the business cycle.
In early 2018, the European Union moved from the incurred loss model of provisioning to an expected loss model, with the implementation of International Financial Reporting Standard (IFRS) 9 on Financial Instruments. The expected credit loss model of IFRS 9 requires banks to set credit impairment allowances for all loans rather than just for loans where loss is probable or has already occurred. The broader application of the expected loss model to all loans should lead to an increase in the average level of allowances. The introduction of IFRS 9 thus could mitigate the negative relationship between provisioning and economic growth, with a potentially positive effect on financial stability.
However, some have argued that the impact of IFRS 9 on the procyclicality of loan loss provisioning is ambiguous. Provisioning for a next economic downturn under the expected credit loss model may be rather abrupt, if an initial turning point in the business cycle is taken to forebode a serious business cycle downturn, triggering large loan loss provisioning in anticipation of future loan impairment. The introduction of the expected credit loss model thus could lead to a concentration of loan loss allowances at the time of an initial economic downturn, with possible negative ramifications for financial stability.
Their evidence on loan loss provisioning has important implications for the supervision of euro area banks going forward. First, the relatively large provisioning cyclicality in the euro area stresses the need to make efforts to reduce this procyclicality, given that this is likely to remain a problem after the introduction of IFRS 9. Second, the considerable heterogeneity in provisioning among euro area banks could reflect that banks apply the accounting rules regarding provisioning unevenly, which should be a concern for bank supervisors. This heterogeneity is also likely to persist under IFRS 9, and hence supervisors will need to apply efforts to make the application of loan loss provisioning rules across euro area banks more uniform. More generally, their findings call for increased attention to potential undesirable consequences of provisioning rules for the procyclicality of lending.