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The cyclicality of loan loss provisions under three different accounting models: the United Kingdom, Spain, and Brazil

ABSTRACT

A controversy involving loan loss provisions in banks concerns their relationship with the business cycle. While international accounting standards for recognizing provisions (incurred loss model) would presumably be pro-cyclical, accentuating the effects of the current economic cycle, an alternative model, the expected loss model, has countercyclical characteristics, acting as a buffer against economic imbalances caused by expansionary or contractionary phases in the economy. In Brazil, a mixed accounting model exists, whose behavior is not known to be pro-cyclical or countercyclical. The aim of this research is to analyze the behavior of these accounting models in relation to the business cycle, using an econometric model consisting of financial and macroeconomic variables. The study allowed us to identify the impact of credit risk behavior, earnings management, capital management, Gross Domestic Product (GDP) behavior, and the behavior of the unemployment rate on provisions in countries that use different accounting models. Data from commercial banks in the United Kingdom (incurred loss), in Spain (expected loss), and in Brazil (mixed model) were used, covering the period from 2001 to 2012. Despite the accounting models of the three countries being formed by very different rules regarding possible effects on the business cycles, the results revealed a pro-cyclical behavior of provisions in each country, indicating that when GDP grows, provisions tend to fall and vice versa. The results also revealed other factors influencing the behavior of loan loss provisions, such as earning management.

Keywords:
provisions; cyclicality; economic cycles; credit operations; commercial banks

RESUMO

Uma polêmica envolvendo a provisão para créditos de liquidação duvidosa em bancos refere-se à sua relação com os ciclos econômicos. Enquanto os padrões contábeis internacionais para o reconhecimento da provisão (modelo de perda incorrida) seriam presumivelmente pró-cíclicos, acentuando os efeitos do ciclo econômico vigente, um modelo alternativo, o modelo de perda esperada, teria características anticíclicas, atuando como uma espécie de amortecedor dos desequilíbrios econômicos próprios das fases de expansão e de contração da economia. No Brasil, vigora um modelo contábil misto, cujo comportamento não se sabe ser pró-cíclico ou anticíclico. Identificar o comportamento desses modelos contábeis frente aos ciclos econômicos, por meio de um modelo econométrico composto por variáveis contábeis e macroeconômicas, foi o objetivo desta pesquisa. O estudo contempla uma discussão sobre o impacto do comportamento do risco de crédito, do gerenciamento de resultados, do gerenciamento de capital, do comportamento do Produto Interno Bruto (PIB) e do comportamento da taxa de desemprego sobre a provisão, em países que utilizam os distintos modelos contábeis. Foram utilizados dados de bancos comerciais do Reino Unido (perda incorrida), da Espanha (perda esperada) e do Brasil (modelo misto), no período de 2001 a 2012. Os resultados revelaram que os modelos contábeis dos três países, apesar de serem formados por regras de natureza bastante distinta no que diz respeito a um eventual efeito sobre os ciclos econômicos, apresentaram comportamento pró-cíclico, indicando que, quando o PIB está em ascensão, as provisões tendem a cair e vice-versa. Os resultados revelaram também outros elementos que podem estar influenciando o comportamento da provisão, como a prática de gerenciamento de resultados.

Palavras-chave:
provisões; ciclicidade; ciclos econômicos; operações de crédito; bancos comerciais

1. INTRODUCTION

According to Longbrake and Rossi (2011Longbrake, W. A., & Rossi, C. V. (2011, July). Procyclical versus countercyclical policy effects on financial markets. Study prepared for the Anthony T. Cluff Fund. The Financial Services Roundtable. Financing America’s Economy. Retrieved from http://www.fsround.org/fsr/pdfs/cluff/CountercyclicalPE.pdf.
http://www.fsround.org/fsr/pdfs/cluff/Co...
), many of the rules that regulate the financial markets contributed to deepening the crisis that affected the global economy in the period between 2007 and 2009, fueling the debate regarding the way the financial system accentuates the effects of expansionary and contractionary phases in the economy. At the heart of the claim lies the concern regarding pro-cyclicality, which represents a positive correlation between a particular variable and economic activity (Bebczuk & Sangiácomo, 2010Bebczuk, R., Carrera, J., & Sangiácomo, M. (2010). A new look into credit procyclicality: International panel evidence. In BIS Consultative Council for the Americas Conference on “systemic risk, bank behavior and regulation over the business cycle”. Buenos Aires, Argentina.).

For Harrald and Sandal (2010Harrald, P., & Sandal, T. (2010, October). Addressing pro-cyclicality. Asia-Risk, 70-72. Retrieved from htttp://www.risk.net. ), pro-cyclicality is the way that the banking system interacts with the real economy and accentuates the effects of an economic cycle. It derives from incentives to accelerate lending in periods of economic expansion and to reduce such activity in times of crisis.

According to Longbrake and Rossi (2011Longbrake, W. A., & Rossi, C. V. (2011, July). Procyclical versus countercyclical policy effects on financial markets. Study prepared for the Anthony T. Cluff Fund. The Financial Services Roundtable. Financing America’s Economy. Retrieved from http://www.fsround.org/fsr/pdfs/cluff/CountercyclicalPE.pdf.
http://www.fsround.org/fsr/pdfs/cluff/Co...
), the financial system should ideally dampen and not amplify business cycles. Pro-cyclicality becomes especially problematic when it accentuates the effect of a fall in the economic cycle and worsens a crisis. Thus, countercyclical rules, which reduce economic imbalances and the depth of business cycles, are welcome.

Also according to these authors, factors that explain the influence of the financial system on the economic environment include the accounting rules that set loan loss provisions. The expression “loan loss provision” (“provisão para créditos de liquidação duvidosa” in Portuguese) is the term used by the Brazilian Central Bank for the estimated losses from loans granted by financial institutions. In international accounting standards, this provision is represented by impairment losses derived from loans and receivables.

For Bikker and Metzemakers (2004Bikker, J. A., & Metzemakers, P. A. J. (2004, March). Bank provisioning behaviour and procyclicality. Journal of International Financial Markets, Institutions & Money, 209, 1-17. doi: 10.1016/j.intfin.2004.03.004.
https://doi.org/10.1016/j.intfin.2004.03...
), the provision leaves room for subjective judgment and allows for discretion when establishing levels considered as “adequate”. The study by these authors identified a direct relationship between the provision set by banks and economic cycles, revealing that income smoothing, capital management, and tax rules also determine the level of provision.

Betancourt and Baril (2009Betancourt, L., & Baril, C. P. (2009, October/November). Accounting for loan losses: Is Dynamic provisioning the answer? Bank Accounting Finance, 22(6), 9-16. Retrieved from http://connection.ebscohost.com/c/articles/44680540/accounting-loan-losses-dynamic-provisioning-answer.
http://connection.ebscohost.com/c/articl...
) observe that at the beginning of a downward economic cycle there is little provision recognized in banks earnings. As the crisis worsens the provisions grow, deteriorating the equity situation of banks and reducing levels of lending when the market needs funds the most. This pro-cyclical behavior is adopted by banks that follow international accounting standards for provisions.

The accounting principles in the United States and those of the International Accounting Standards Board (IASB) adopt the incurred loss model, establishing that a loss in credit operations will only be recognized in earnings if its occurrence (related to a loss event) is likely and its value can be estimated with certainty.

According to Betancourt and Baril (2009Betancourt, L., & Baril, C. P. (2009, October/November). Accounting for loan losses: Is Dynamic provisioning the answer? Bank Accounting Finance, 22(6), 9-16. Retrieved from http://connection.ebscohost.com/c/articles/44680540/accounting-loan-losses-dynamic-provisioning-answer.
http://connection.ebscohost.com/c/articl...
), an alternative to the incurred loss model is the expected loss model, which recognizes provisions based on expected future losses, independently of objective evidence. This model uses as a reference the dynamic provision adopted by the Banco de España, which accepts the setting of a generic provision to protect banks against possible additional losses in a particular economic cycle.

In Brazil, Resolution n. 2,682/1999 of the National Monetary Council rules that the provision should be set based on the operation risk level and its value should be reviewed at least monthly, depending on the delay in the payment of principal or interest. This involves a mixed system with characteristics of expected loss (provisions based on future losses expectations) and incurred loss (provisions based on objective evidence represented by delays in payment).

The three accounting models would cause different behaviors of the provision in relation to economic cycles. In order to confirm this assumption, the relationship between the accounting criteria for setting provisions in banks and economic cycles should be investigated.

Studies such as those by Bikker and Metzemakers (2004Bikker, J. A., & Metzemakers, P. A. J. (2004, March). Bank provisioning behaviour and procyclicality. Journal of International Financial Markets, Institutions & Money, 209, 1-17. doi: 10.1016/j.intfin.2004.03.004.
https://doi.org/10.1016/j.intfin.2004.03...
) and by Boutavier and Lepetit (2007Bouvatier, V., & Lepetit, L. (2007). Banks’ procyclical behavior: Does provisioning matter? Journal of International Financial Markets, Institutions & Money, 18, 513-528. doi: 10.1016/j.intfin.2007.07.004.
https://doi.org/10.1016/j.intfin.2007.07...
) have already been conducted to investigate the relationship between loan loss provisions and economic cycles. Besides being restricted to certain aspects of the provision, these studies used relatively different models and variables, thus leaving room for new analyses on the topic.

There are few studies involving the Brazilian model, which is presumably countercyclical since most of the value of the provisions is the result of classifying operations by level of risk at the time of lending and not migration between the risk categories due to credit defaults.

The aim is to analyze whether the accounting models involved in setting loan loss provisions in banks are pro-cyclical, countercyclical, or acyclical, using an econometric model with a consistent theoretical framework and empirical construction.

A panel data econometric model was specified in which the loan loss provision expense in relation to total assets is regressed against the variation in Gross Domestic Product (GDP), under the control of the unemployment rate and accounting variables that affect the provision. An identical specification is run for samples from three different provision accounting systems (United Kingdom, Spain, and Brazil) with the aim of verifying whether the covariance between the provision and GDP is significantly positive (countercyclical), negative (pro-cyclical), or without significance (acyclical).

The results indicated a negative and significant association between the provision expense and GDP in the three countries, signaling that the empirically confirmed pro-cyclical behavior is independent of the provision model adopted. One probable assumption regarding this finding is that the banks may be using discretion and engaging in earnings management via the provision and more than compensating for the expected effect of the models, but this is a hypothesis to be investigated in future research.

Besides this introduction, this paper presents the literature review in section 2; section 3 formulates the three research hypotheses; section 4 details the methodology; section 5 presents, analyzes, and discusses the results; and section 6 offers some final remarks.

2. CONSIDERATIONS REGARDING ECONOMIC CYCLES AND PRO-CYCLICALITY

A classic definition of “economic cycle”, or “business cycle”, is that of Burns and Mitchell (1946Burns, A. F., & Mitchell, W. C. (1946). Measuring business cycles. NBER Book Series Studies in Business Cycles, New York: National Bureau of Economic Research.):

Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions, and revivals which merge into the expansion phase of the next cycle; in duration business cycles vary from more than one year to ten or twelve years.

For Harrald and Sandal (2010Harrald, P., & Sandal, T. (2010, October). Addressing pro-cyclicality. Asia-Risk, 70-72. Retrieved from htttp://www.risk.net. ), pro-cyclicality is the way in which the banking system interacts with the real economy, accentuating the effects of an economic cycle. The pro-cyclicality cost depends on the extent to which the effects of the cycle are accentuated and the fact that these effects are damaging to the economy. Pro-cyclicality derives from incentives for the acceleration of lending in periods of expansion and the reduction in such activity in crises.

According to Bebczuk et al. (2010Bebczuk, R., Carrera, J., & Sangiácomo, M. (2010). A new look into credit procyclicality: International panel evidence. In BIS Consultative Council for the Americas Conference on “systemic risk, bank behavior and regulation over the business cycle”. Buenos Aires, Argentina.), pro-cyclicality is a synchronized movement in the growth of credit and production, both in time t. Excessive cyclicality in lending can lead to problems such as exacerbating the economic cycle, an increase in systemic risk, and the inadequate allocation of resources for loans.

For Gonzales (2009Gonzales, J. E. N. (2009, July). The fundamentals of procyclicality of the financial system. Economic Newsletter. Bangko Sentral NG Pilipinas, 9(3). Retrieved from http://www.bsp.gov.ph/downloads/EcoNews/EN09-03.pdf.
http://www.bsp.gov.ph/downloads/EcoNews/...
), pro-cyclicality is present when the actions of banks tend to reinforce the movements of the underlying business cycles, indicating a correlation between the aforementioned actions and the current economic environment. Pro-cyclical measures are, therefore, those that contribute to strengthening the current economic cycle.

3. LOAN LOSS PROVISIONS IN BANKS

Hendriksen and Van Breda (1999Hendriksen, E. S., & Van Breda, M. F. (1999). Teoria da contabilidade. São Paulo, SP: Atlas.) state that an important element in evaluating receivables is the treatment of uncertainty with regards to their payment by the client. Thus, revenue should be measured by the value that it is expected will be received. In the quality of the value reserve, the provision adjusts the gross value of loans according to their credit risk. This adjustment has a direct effect on the income calculation, affecting the amount to be paid out to shareholders.

3.1. Provision Models

Banks’ provision rules can be: (i) backward-looking, based on losses incurred in operations and considering the events and conditions prior to the balance sheet; and (ii) forward-looking, set by considering expected losses and based on trend analyses (Bouvatier & Lepetit, 2012Bouvatier, V., & Lepetit, L. (2012, July). Provisioning rules and bank lending: A theoretical model. Journal of Financial Stability, 8(2), 25-31. Retrieved from http://ssrn.com/abstract=1148314.
http://ssrn.com/abstract=1148314...
).

According to Cortavarria, Dziobek, Kanaya, and Song (2000Cortavarria, L., Dziobek, C., Kanaya, A., & Song, I. (2000, December). Loan review, provisioning, and macroeconomic linkages. WP/00/195. IMF Working Paper. International Monetary Fund. Retrieved from http://www.imf.org/external/pubs/ft/wp/2000/wp00195.pdf.
http://www.imf.org/external/pubs/ft/wp/2...
), provisions can be generic and specific. Generic provisions are possible or latent losses not yet identified (ex-ante) and applicable to all operations. Specific provisions reflect individually identified losses related to an observable event (ex-post).

3.2. Earnings Management via Provisions

Accounting rules allow for the use of discretion and judgment in the financial statements preparation (Cohen & Zarowin, 2007Cohen, D. A, & Zarowin, P. (2007, August). Earnings management over the business cycle. New York University. Stern School of Business. Retrieved from http://w4.stern.nyu.edu/emplibrary/EM_08_23_07FINAL.pdf.
http://w4.stern.nyu.edu/emplibrary/EM_08...
). This enables the use of business knowledge and expertise to choose the most appropriate accounting methods, estimates, and disclosure. The problem is when managers find incentives to convey information to their own benefit, choosing accounting methods and accounting estimates that do not adequately reflect the underlying economic conditions.

For Cohen and Zarowin (2007Cohen, D. A, & Zarowin, P. (2007, August). Earnings management over the business cycle. New York University. Stern School of Business. Retrieved from http://w4.stern.nyu.edu/emplibrary/EM_08_23_07FINAL.pdf.
http://w4.stern.nyu.edu/emplibrary/EM_08...
), this accounting information discretion can be both a value maximizer and opportunistic, leaving room for “earnings management”. Earnings management can be achieved via the manipulation of accruals, which according to Martinez (2001Martinez, A. L. (2001). “Gerenciamento” dos resultados contábeis: estudo empírico das companhias abertas brasileiras (Ph.D. thesis). Faculdade de Economia, Administração e Contabilidade, Universidade de São Paulo, São Paulo, SP., p. 29) represent “the difference between net income and net cash flow”, or via real transactions, such as a reduction in spending on research and development. In the case of provision, earnings management occurs through accruals manipulation. For Martinez (2001Martinez, A. L. (2001). “Gerenciamento” dos resultados contábeis: estudo empírico das companhias abertas brasileiras (Ph.D. thesis). Faculdade de Economia, Administração e Contabilidade, Universidade de São Paulo, São Paulo, SP.), when it is left to managers to make accounting choices, they may not limit themselves to accounting facts alone and use exogenous variables, which will also influence the decision. Thus, provision will also consider aspects that extrapolate credit quality.

Studies have revealed indications of earnings management being practiced by financial institutions in Brazil, based on the use of loan loss provisions. Macedo and Kelly (2016Macedo, M. A. S., & Kelly, V. L. A. (2016, May/August). Gerenciamento de resultados em instituições financeiras no Brasil: uma análise com base em provisões para crédito de liquidação duvidosa. Revista Evidenciação Contábil & Finanças, 4(2), 82-96.) identified that from 2006 to 2012 the income level obtained by financial institutions influenced these provisions. Bortoluzzo, Sheng, and Gomes (2016Bortoluzzo, A. B., Sheng, H. H., & Gomes, A. L. P. (2016) Earning management in Brazilian financial institutions. Revista de Administração da Universidade de São Paulo, 51(2), 182-197. ISSN 0080-2107. doi: 10.5700/rausp1233.
https://doi.org/10.5700/rausp1233...
) found similar results by analyzing the behavior of 123 Brazilian banks between 2001 and 2012. Silva (2016Silva, C. A. M. (2016). Utilização da provisão para créditos de liquidação duvidosa para fins de gerenciamento de resultado nas instituições financeiras brasileiras e luso-espanholas (Master’s thesis). Faculdade de Economia, Administração e Contabilidade, Universidade de Brasília, Brasília, DF.) showed that between June 2009 and December 2014 Brazilian and Luso-Spanish banking institutions used provision expenses to manage earnings. Cursio and Hasan (2015Curcio, D., & Hasan, I. (2015). Earnings and capital management and signaling: The use of loan-loss provisions by European banks. The European Journal of Finance, 21(1), 26-50. doi: 10.1080/1351847X.2012.762408.
https://doi.org/10.1080/1351847X.2012.76...
) found that from 1996 to 2006 earnings management was shown to be an important determinant of the provisions of financial intermediaries that operate in the Euro zone.

3.3. Capital Management via Provisions

In the capital management hypothesis, banks set higher provisions when their regulatory capital is relatively low. According to Bikker and Metzemakers (2004Bikker, J. A., & Metzemakers, P. A. J. (2004, March). Bank provisioning behaviour and procyclicality. Journal of International Financial Markets, Institutions & Money, 209, 1-17. doi: 10.1016/j.intfin.2004.03.004.
https://doi.org/10.1016/j.intfin.2004.03...
), this occurs because the Basel Accord allows for the accumulated provisions in the balance sheet, although limited to a percentage of risk-weighted assets, to comprise banks’ regulatory capital. This allowance occurs only in relation to level 2 capital, which is the lowest quality regulatory capital and whose value cannot exceed the value of level 1 capital, taken as main capital.

3.4. Studies Relating the Provision to Economic Cycles

Table 1 lists studies involving the pro-cyclicality of the provision in banks.

Table 1
Summary of the main articles involving the analysis of the pro-cyclicality of the loan loss provision in financial institutions.

4. RESEARCH HYPOTHESES

  • H 1  Provisions based on the incurred loss model present a negative relationship with the variables that represent economic activity, contributing towards enhancing possible contractions experienced by the economy, or towards amplifying the effects of favorable economic cycles. They are pro-cyclical in nature.
  • H 2  Provisions based on the expected loss model present a positive relationship with the variables that represent economic activity, preventing possible contractions in the economy from being enhanced, or the effects of favorable economic cycles from being amplified. They are countercyclical in nature.
  • H 3  Provisions based on the mixed model adopted in Brazil present a positive relationship with the variables that represent economic activity, preventing possible contractions experienced by the economy from being enhanced, or the effects of favorable economic cycles from being amplified. They are countercyclical in nature.

5. METHODOLOGY

5.1. Presentation of the Model and Discussion of the Variables

A linear regression model was defined to evaluate the relationship between the variables of interest in order to identify how the provisions are associated with the variables that characterize business cycles. Most of the studies relating provisions and economic cycles use this type of model, such as Cavallo and Majnoni (2001Cavallo, M., & Majnoni, G. (2001, June). Do banks provision for bad loans in good times? Empirical evidence and policy implications. Working Paper Nº 2.619. World Bank Policy Research. Retrieved from https://openknowledge.worldbank.org/handle/10986/19607.
https://openknowledge.worldbank.org/hand...
), Bikker and Hu (2002Bikker, J. A., & Hu, H. (2002). Cyclical patterns in profits, provisioning and lending of banks and procyclicality of the new basel capital requirements. Banca Nazionale del Lavaro Quarterly Review, 55(221), 143-175. Retrieved from https://www.dnb.nl/binaries/ot039_tcm46-146052.pdf.
https://www.dnb.nl/binaries/ot039_tcm46-...
), Laeven and Majnoni (2003Laeven, L., & Majnoni, G. (2003, April). Loan loss provisioning and economic slowdowns: too much, too late? Journal of Financial Intermediation, 12(2), 178-197. Retrieved from http://www.sciencedirect.com/science/article/pii/S1042957303000160.
http://www.sciencedirect.com/science/art...
), Bikker and Metzemakers (2004)Bikker, J. A., & Metzemakers, P. A. J. (2004, March). Bank provisioning behaviour and procyclicality. Journal of International Financial Markets, Institutions & Money, 209, 1-17. doi: 10.1016/j.intfin.2004.03.004.
https://doi.org/10.1016/j.intfin.2004.03...
, Handorf and Zhu (2006Handorf, W. C., & Zhu, L. (2006, spring). US Bank loan-loss provisions, economic conditions, and regulatory guidance. Journal of Applied Finance, 16(1), 97-114. Retrieved from http://search.proquest.com/openview/ee52c0978ed6e519591ff513944a8a54/1?pq-origsite=gscholar&cbl=26518.
http://search.proquest.com/openview/ee52...
), Bouvatier and Lepetit (2007Bouvatier, V., & Lepetit, L. (2007). Banks’ procyclical behavior: Does provisioning matter? Journal of International Financial Markets, Institutions & Money, 18, 513-528. doi: 10.1016/j.intfin.2007.07.004.
https://doi.org/10.1016/j.intfin.2007.07...
), and Glen and Mondragón-Vélez (2011Glen, J., & Mondragón-Vélez, C. (2011, January). Business cycle effects on commercial bank loan portfolio performance in developing economies. Review of Development Finance, 1(2), 150-165. Retrieved from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1754672.
http://papers.ssrn.com/sol3/papers.cfm?a...
).

The model is estimated using the panel data method. The empirical tests use the model below, elaborated based on the aims and hypotheses of the research:

P R O V i t = β 0 + β 1 G D P t + β 2 U N E M P t + β 3 E A R i t + β 4 l n L O A N i t + β 5 L O A N i t + β 6 N E i t + β 7 S I Z E i t i + ε i t (1)

where:

  • PROVit = loan loss provision over banks’ average total assets i in time t.

  • GDP t = real variation in GDP in time t.

  • UNEMPt = unemployment rate in time t.

  • EARit = earnings before income tax, profit sharing, and loan loss provisions over banks’ average total assets i in time t.

  • lnLOAN it = variation in the loan balances of banks i in time t.

  • LOANit = balance of credit operations over total assets of banks i in time t.

  • NEit = equity over total assets of banks i in time t.

  • SIZEit = size of banks i in time t.

The aim of the model is not to capture a possible cause and effect relationship between dependent variables and independent variables, but rather, to identify how the dependent variable behaves in relation to variations in each independent variable, especially the macroeconomic ones.

Despite the accounting variables being endogenous, their inclusion in the model is warranted because the provision is influenced by prominently accounting factors, such as receivables, earnings, and equity. Moreover, these variables work as control variables, helping to more adequately capture the relationship between the dependent and the independent variables, taken as critical to the study (GDP and unemployment rate).

Most of the models that study the provision-economic cycle relationship use the provision as a dependent variable. In this study, it represents the net amount of provision expenses set in the period, obtained by the difference between the set and the reverted provisions.

The independent variables can be classified into: (i) macroeconomic variables for the countries (real GDP growth and unemployment rate); (ii) accounting variables for the banks (earnings before income tax, profit sharing, and loan loss provisions over average total assets, variation in loan balances, loan balances over total assets, and equity over total assets); and (iii) a control variable (bank size).

The real variation in GDP is a critical variable in the model and considered a more useful indicator for representing the business cycle. Its value represents the percentage variation in GDP at constant prices.

The unemployment rate is another representative metric of the current phase of the economic cycle. In Brazil, it indicates the joblessness rate for 10-year-olds upwards, considering only the main metropolitan regions of the country.

The earnings over total assets variable, which indicates a possible use of the provision for earnings management, is the result of dividing the value of earnings before income tax, profit sharing, and loan loss provisions by the average value of total assets.

The growth in lending variable, which indicates the evolution of the banks’ credit risk, represents the variation in the balances of credit operations in real terms. In the Brazilian case, the deflator used was the General Market Price Index (IGPM). For Spain and the United Kingdom, the Consumer Price Index (CPI) was used. The variation in the balances of loans was calculated by the difference in the natural logarithms in the following way: ln(credit operationsit/IGPMit) - ln(credit operationsit-1/IGPMit-1).

The loans over total assets variable considers the exposure of the banks to credit risks, indicating the relative size of the loans portfolio. It represents the division of the balance of receivables from credit operation accounts by the value of total assets.

The equity over total assets variable, inserted into the model to indicate a possible use of the provision as a capital management tool, is the result of dividing net equity by total assets.

The SIZEititalic> variable, defined as the natural logarithm of total assets, deflated by the IGPM or the CPI, aims to control the size effects of the institutions. Larger banks, or those participating in conglomerates, are expected to set more robust provisions.

5.2. Summary of the Expected Results

Table 2 summarizes the expected results in relation to the behavior and to the sign of the coefficients of the explanatory variables, based on the formulated hypotheses.

Table 2
Summary of the expected results in relation to the model explanatory variables.

5.3. Tests Applied and Robustness Procedures Adopted

The Im, Pesaran, and Shin - I.P.S, ADF-Fisher, and PP-Fisher unitary root tests indicated that in the countries studied the risk of a spurious regression was removed.

The Pearson correlation matrix (tables 3, 4, and 5) proved that a high correlation (above 0.8) did not exist between the independent variables in the countries analyzed.

Table 3
Pearson Correlation Matrix - Brazil.
Table 4
Pearson correlation matrix - Spain.
Table 5
Pearson correlation matrix - United Kingdom.

The risk of multicollinearity was analyzed by applying the variance inflation test among the explanatory variables, which did not reveal multicollinearity problems.

The Chow test was carried out to test the existence of individual heterogeneity and confirm whether the use of panel data would apply to the study. In the three countries, the option was to use the regression with individual effects. Then the Hausman test was carried out to define the best panel data method for the regression estimation. For Brazil, the result indicated the random effects model. For Spain and the United Kingdom, it was the fixed effects model.

In order to analyze the existence of autocorrelation between the residuals of the regression, the Durbin-Watson test was used. In the three countries, the value of the statistic was between dl and du , indicating that the test was inconclusive. Adopting a conservative position, the null hypothesis of the inexistence of autocorrelation is rejected; that is, the model residuals appear to be autocorrelated.

In light of the possibility of the existence of cross-sectional autocorrelation of the residuals, the use of the SUR cross-sectional standard errors method (PCSE) in the model estimation arose as an alternative to the problem, enabling the generation of robust parameters even in the presence of residues autocorrelation.

The overall significance of the model was proven using the F test.

5.4. Sample Definition and Description of the Data Source

5.4.1 In relation to the banks that operate in Brazil.

In Brazil, the sample considered the institutions that formed part of Consolidated Banking I, formed by Banking Conglomerate I (composed of at least one institution of the Commercial Bank or Multiple Bank with Commercial Portfolio type) and Independent Banking Institutions I (Commercial Banks, Multiple Banks with Commercial Portfolio, and Savings Banks that do not form part of a conglomerate).

Ninety-eight institutions were initially considered. Together, these institutions controlled 84.1% of the total assets of the National Financial System on December 31st 2012.

Banco Plural, Morgan Stanley, Banco BM&F, Banco Opportunity, BNY Mellon, Western Union, and Banco Petra were excluded from the sample as they did not present a credit operations balance in the period analyzed.

Data was extracted from the semi-annual financial statements of the chosen institutions on June 30st and December 31st between 2001 and 2012, obtained from the Banco Central do Brasil website.

5.4.2. In relation to the banks that operate in Spain.

The sample considered all of the Spanish banks associated with the Asociación Española de Banca (AEB). Fifty-eight institutions, including financial conglomerates and individuals banks, were considered in the study.

5.4.3. In relation to the banks that operate in the United Kingdom.

The selection of banks that operate in the United Kingdom was based on the publication “List of Banks as Compiled by the Bank of England on 31 March 2013”, which covers the list of banks under the supervision of the Bank of England, available from the website www.bankofengland.co.uk. The list is comprised of 153 financial institutions, with 45 banks being selected to compose the sample (29.41% of the supervised institutions). The sample prioritized institutions closing their financial year on December 31st and which presented their information in identical monetary bases (pounds sterling). The information was obtained from the Company Check website (www.companycheck.co.uk), which provides the annual financial statements of banks operating in the United Kingdom.

6. RESULTS

6.1. Descriptive Statistics of the Dependent Variable

The descriptive statistics of the dependent variable are found in Table 6. From the second semester of 2001 to the second semester of 2012, the commercial banks that operated in Brazil, in Spain, and in the United Kingdom set, on average, provisions in percentages equal to 0.83%, 0.2668%, and 0.3607% of total assets, respectively. The standard deviations show a large variability in the provision, perhaps caused by the reversion mechanism, and indicate that the frequency distributions of the provision in the three countries have a similar behavior.

Table 6
Descriptive statistics of the dependent variable in the model - Brazil, Spain, and the United Kingdom, from 2001 to 2012.

6.2. Descriptive Statistics of the Independent Variables

6.2.1. Brazil.

Table 7
Descriptive statistics of the independent variables in the model - Brazil, 2001-2012.

According to Table 7, on average only 34.34% of the resources were used for credit operations, a lower percentage than those of the banks that operate in Spain and the United Kingdom, which were around 82% and 71%, respectively.

The average share of own resources over the total investments of the commercial banks has shown to be quite significant, at around 23%, and more comfortable than that of the banks that operate in Spain (average of 20%) and much higher than that of the banks that operate in the United Kingdom (average of 13.8%).

6.2.2. Spain.

Table 8 presents the descriptive statistics of the independent variables in relation to the banks that operate in Spain. The average return on assets was around 0.53%, below the returns of the banks that operate in Brazil (2.25%) and in the United Kingdom (1.91%).

Table 8
Descriptive statistics of the independent variables in the model - Spain, 2001-2012.

6.2.3. United Kingdom.

The descriptive statistics of the independent variables related to the banks that operate in the United Kingdom are presented in Table 9.

Table 9
Descriptive statistics of the independent variables in the model - United Kingdom, 2001-2012.

6.3. Test of the Hypotheses

6.3.1. H1: Banks that operate in the United Kingdom

The coefficient of determination (R2) indicates that the independent variables are associated with 38.87% of the behavior of the dependent variable. The F statistic, with a p-value of 0.0000, confirms the statistical significance of the model (Table 10).

Table 10
Coefficients of Determination and F Statistic of the model - United Kingdom.

The macroeconomic variables and the specific accounting variables of the banks, except GDP, do not have significant effects on the provision in the United Kingdom. The “loans over total assets” and “growth in lending” variables were not found to be significant, thus going against the expectations presented in Table 2.

The “earnings before income tax, profit sharing, and loan loss provisions over total assets” variable was also not found to be significant, indicating that variations in earnings would not explain the behavior of the provision and going against the expectations of the research. Earnings management via provisions does not appear to be a common practice among banks in the United Kingdom.

Table 11
Regression results - United Kingdom.

The “net equity over total assets” variable was not found to be significant, thus going against the capital management hypothesis.

At a 1% level of significance, the coefficient of the “GDP growth” variable was found to be significantly negative, indicating pro-cyclical behavior of the banks in the United Kingdom, in line with hypothesis H1.

The “unemployment rate growth” variable was only found to be significant at a 10% level of significance, thus going against the expectations. This result, however, supports the findings of previous studies, such as Bikkers and Metzemakers (2004Bikker, J. A., & Metzemakers, P. A. J. (2004, March). Bank provisioning behaviour and procyclicality. Journal of International Financial Markets, Institutions & Money, 209, 1-17. doi: 10.1016/j.intfin.2004.03.004.
https://doi.org/10.1016/j.intfin.2004.03...
).

The “size” control variable was also not found to be significant.

6.3.2. H2: Banks that operate in Spain.

With regards to the banks that operate in Spain, the coefficient of determination (R2) indicates that the independent variables are associated with 38.31% of the dependent variable behavior. The F statistic, with a p-value of 0.0000, confirms the statistical significance of the model (Table 12).

Table 12
Coefficients of determination and F statistic of the model - Spain.
Table 13
Regression results - Spain.

The “loans over total assets”, “earnings over total assets”, “GDP growth” and “size” variables have significant effects on loan loss provisions in Spain, at different levels of significance, as can be observed in Table 13. The other variables were not significant.

The “loans over total assets” variable was not found to be significant, at a 10% level of significance. The positive sign of the coefficient supports the expectation presented in Table 2, indicating that the provision tends to rise when the share of loans over total assets increases.

Contrary to expectations, the “growth in lending” variable was not found to be significant, indicating that the variation in the volume of lending does not explain the behavior of the provisions.

The “earnings before income tax, profit sharing, and loan loss provisions over total assets” variable was not found to be significant in Spain, at a 1% level of significance. The negative sign of the coefficient indicates growth of the provision whenever earnings decrease and vice-versa, thus going against expectations. There is no evidence of earnings management practices via provisions in the Spanish banks.

The “net equity over total assets” variable is not significant, thus going against the expectation with regards to the use of the provision for earnings management.

Contrary to the expectation of hypothesis H2, at a 1% level of significance the coefficient of the “GDP growth” variable was found to be significantly negative, indicating pro-cyclical behavior.

The “unemployment rate” variable was not found to be significant, going against expectations. The “size” control variable was found to be significant, with a positive sign, indicating that the larger the bank, the higher the provision tends to be.

6.3.3. H3: Banks that operate in Brazil.

The coefficient of determination (R2) indicates that the independent variables of the model are associated with 15.65% of the dependent variable behavior (Table 14). The F statistic, which presents a p-value equal to 0.0000, confirms the statistical significance of the model.

Table 14
Coefficients of determination and F statistic of the model - Brazil.
Table 15
Regression results - Brazil.

According to the data in Table 15, the macroeconomic variables and the specific accounting variables of the banks studied in Brazil, with the exception of the unemployment rate and size, have significant effects on the provision.

The “loans over total assets” variable was found to be significant at a 1% level of significance. As expected, when a bank increases its share of credit operations in total investments, the percentage of the provision also increases, confirming the claim of growth in risks in phases of economic expansion. This prudent behavior of the banks contributes to attenuating the effects caused by possible pro-cyclical behaviors.

The “growth in lending” variable was only found to be significant at a 10% level of significance. The coefficient presented a negative sign, indicating that the provisions usually decrease when the balance of credit operations increases. This finding would go against the initial expectation, which indicated a probable positive relationship between growth in the lending volume and the provision.

The “earnings before income tax, profit sharing, and loan loss provisions over total assets” variable was also found to be significant at a 1% level of significance, indicating that variations in earnings are related with the behavior of the provision. The positive sign of the coefficient indicates growth in provision levels whenever earnings increase and vice-versa, thus supporting the expectation presented in Table 2. The result indicates the use of the provision for earnings management, a practice which ameliorates the pro-cyclical effects of the provision.

The “net equity over total assets” variable was shown to be significant at a 1% level of significance. The negative sign of the coefficient would go against the expectation of use of the provision for capital management; it is supposed that the banks raise the provision whenever their capital levels are more comfortable. It is assumed that the fact that the banks in Brazil have historically presented a higher reference equity than that required by the Central Bank and the absence itself of the generic provision instrument in the country’s regulation explain this result.

Regarding hypothesis H3, at a 1% level of significance the coefficient of the “GDP growth” variable was shown to be significantly negative, indicating pro-cyclical behavior. This appears to indicate the absence of an efficient risk evaluation mechanism with a forward-looking character.

With regards to the “growth in the unemployment rate” variable, this was not found to be significant, thus going against the expectation presented in Table 2. The same occurs with the “size” control variable. It cannot be claimed that larger banks in Brazil, or those belonging to conglomerates, set more robust provisions than the rest.

As a sensitivity analysis, the lagged GDP and unemployment rate variables were added to the models. In Brazil and the United Kingdom, these variables were not found to be significant, indicating that the effect of their behavior on the provision calculation occurs in the same accounting period. With regards to Spain, the unemployment rate variable was not found to be significant, but the GDP variable was shown to be significant at a 1% level of significance.

7. FINAL REMARKS

Studies such as those by Bikker and Hu (2002Bikker, J. A., & Hu, H. (2002). Cyclical patterns in profits, provisioning and lending of banks and procyclicality of the new basel capital requirements. Banca Nazionale del Lavaro Quarterly Review, 55(221), 143-175. Retrieved from https://www.dnb.nl/binaries/ot039_tcm46-146052.pdf.
https://www.dnb.nl/binaries/ot039_tcm46-...
), Laeven and Majnoni (2003Laeven, L., & Majnoni, G. (2003, April). Loan loss provisioning and economic slowdowns: too much, too late? Journal of Financial Intermediation, 12(2), 178-197. Retrieved from http://www.sciencedirect.com/science/article/pii/S1042957303000160.
http://www.sciencedirect.com/science/art...
), and Bikker and Metzemakers (2004Bikker, J. A., & Metzemakers, P. A. J. (2004, March). Bank provisioning behaviour and procyclicality. Journal of International Financial Markets, Institutions & Money, 209, 1-17. doi: 10.1016/j.intfin.2004.03.004.
https://doi.org/10.1016/j.intfin.2004.03...
) reveal that the choice between different accounting models would determine the behavior of the provision with relation to the business cycles. The expectation is that the incurred loss model leads to pro-cyclical behavior of the provision and the expected loss model results in countercyclical behavior of the provision. This study proposed to investigate whether the incurred loss models, which are conceptually pro-cyclical, would lead banks to setting pro-cyclical provisions, and whether the expected loss models, which are conceptually countercyclical, would lead banks to recognizing countercyclical provisions.

Two countries were intentionally chosen to represent these accounting models: Spain (expected loss) and the United Kingdom (incurred loss). A mixed model adopted in Brazil was also analyzed. The prevalence of typical procedures of expected loss models reinforced the hypothesis that the Brazilian model would be countercyclical.

Based on the linear regression models used in previous studies, especially those by Cavallo and Majnoni (2001Cavallo, M., & Majnoni, G. (2001, June). Do banks provision for bad loans in good times? Empirical evidence and policy implications. Working Paper Nº 2.619. World Bank Policy Research. Retrieved from https://openknowledge.worldbank.org/handle/10986/19607.
https://openknowledge.worldbank.org/hand...
), Bikker and Hu (2002Bikker, J. A., & Hu, H. (2002). Cyclical patterns in profits, provisioning and lending of banks and procyclicality of the new basel capital requirements. Banca Nazionale del Lavaro Quarterly Review, 55(221), 143-175. Retrieved from https://www.dnb.nl/binaries/ot039_tcm46-146052.pdf.
https://www.dnb.nl/binaries/ot039_tcm46-...
), Laeven and Majnoni (2003Laeven, L., & Majnoni, G. (2003, April). Loan loss provisioning and economic slowdowns: too much, too late? Journal of Financial Intermediation, 12(2), 178-197. Retrieved from http://www.sciencedirect.com/science/article/pii/S1042957303000160.
http://www.sciencedirect.com/science/art...
), and Bikker and Metzemakers (2004Bikker, J. A., & Metzemakers, P. A. J. (2004, March). Bank provisioning behaviour and procyclicality. Journal of International Financial Markets, Institutions & Money, 209, 1-17. doi: 10.1016/j.intfin.2004.03.004.
https://doi.org/10.1016/j.intfin.2004.03...
), variables were selected to compose an econometric model that identified the relationship between the provision and the economic cycles in the three countries selected.

Two variables were inserted into the model in order to identify the relationship between the provision and economic cycles: the real variation in GDP and the unemployment rate. Contrary to expected, the unemployment rate was not found to be statistically significant in Brazil or in Spain. In United Kingdom this variable was found to be significant, at a 10% significance level, presenting a positive coefficient, which indicates that the provision tends to grow when the unemployment rate increases. It bears mentioning that studies such as those by Bikker and Metzemakers (2004Bikker, J. A., & Metzemakers, P. A. J. (2004, March). Bank provisioning behaviour and procyclicality. Journal of International Financial Markets, Institutions & Money, 209, 1-17. doi: 10.1016/j.intfin.2004.03.004.
https://doi.org/10.1016/j.intfin.2004.03...
) have already revealed that the unemployment rate would not be the best proxy to evaluate the relationship between the provision and economic cycles, a fact that is supported by this study.

The variable unanimously taken in the studies involving cyclicality is the variation in GDP. The findings of this research are consistent with these studies, as GDP was also found to be a statistically significant variable at a level of significance of practically 1% for each accounting model that was the object of this research.

With regards to the sign of the coefficient of the variable that reflects GDP, two of the formulated hypotheses were not supported. The biggest surprise was in Spain, whose accounting model prescribes setting forward-looking provisions, including provisions of a generic nature, which should cause countercyclical provisions. The sign of the coefficient of the variable, which would presumably be positive, was found to be negative, indicating pro-cyclicality. In Brazil, despite the general rule being to set forward-looking provisions, and although backward-looking previsions ultimately prevail when the delays in the payments of principal and interest are present, the study also revealed pro-cyclical behavior. It is inferred that the subjective character of the provision and the difficulty itself of predicting future economic scenarios, among other factors, could be leading to provisions of a different nature from that which the legislator intended when establishing more specific criteria for setting them. Only in relation to the United Kingdom was the hypothesis confirmed that the accounting model adopted, based essentially on the IASB rules, has in fact caused provisions that are pro-cyclical in nature.

Also in relation to the United Kingdom, only the GDP growth variable was found to be significant, at a 5% level of significance. It is assumed that the variables that represent credit risk, such as “loans over total assets” and “growth in lending” were not found to be significant due to the characteristics of the accounting model itself adopted in that country, which only recognizes the provision when objective evidence of loss is identified. Thus, the impact of the two variables would only occur indirectly (a greater share of loans over assets or growth in the volume of lending can lead to a higher probability of occurrence of objective evidence of loss in the future). These variables can, therefore, change without the banks in the United Kingdom having adjusted their provisions. In the United Kingdom, there was also no evidence found that the banks are using the provision for earnings management, thus contradicting the study by Silva (2016Silva, C. A. M. (2016). Utilização da provisão para créditos de liquidação duvidosa para fins de gerenciamento de resultado nas instituições financeiras brasileiras e luso-espanholas (Master’s thesis). Faculdade de Economia, Administração e Contabilidade, Universidade de Brasília, Brasília, DF.), or for capital management.

With regards to earnings management, this is assumed to be a reality for commercial banks in Brazil, thus supporting the results of the studies by Macedo and Kelly (2016Macedo, M. A. S., & Kelly, V. L. A. (2016, May/August). Gerenciamento de resultados em instituições financeiras no Brasil: uma análise com base em provisões para crédito de liquidação duvidosa. Revista Evidenciação Contábil & Finanças, 4(2), 82-96.), Bortoluzzo, Sheng, and Gomes (2016Bortoluzzo, A. B., Sheng, H. H., & Gomes, A. L. P. (2016) Earning management in Brazilian financial institutions. Revista de Administração da Universidade de São Paulo, 51(2), 182-197. ISSN 0080-2107. doi: 10.5700/rausp1233.
https://doi.org/10.5700/rausp1233...
), and Silva (2016Silva, C. A. M. (2016). Utilização da provisão para créditos de liquidação duvidosa para fins de gerenciamento de resultado nas instituições financeiras brasileiras e luso-espanholas (Master’s thesis). Faculdade de Economia, Administração e Contabilidade, Universidade de Brasília, Brasília, DF.). The “earnings before income tax, profit sharing, and loan loss provisions” variable was found to be significant, at a 1% level of significance, having presented a positive coefficient indicating that the provision tends to grow when the banks’ earnings increase. In relation to Spain, despite the significance at a 1% level of significance, this variable presented a negative sign, signaling that the provision decreases when earnings increase and thus contradicting the study by Silva (2016Silva, C. A. M. (2016). Utilização da provisão para créditos de liquidação duvidosa para fins de gerenciamento de resultado nas instituições financeiras brasileiras e luso-espanholas (Master’s thesis). Faculdade de Economia, Administração e Contabilidade, Universidade de Brasília, Brasília, DF.).

Earnings management practices, which are reprehensible in some aspects, can represent a counterpoint to setting pro-cyclical provisions, easing their effects on the current phase of the business cycle.

Capital management practices were also not found to be a reality for the commercial banks in Brazil and Spain. In Brazil, despite the significance at a level of 1%, the aforementioned variable presented a positive coefficient, indicating that the greater the share of net equity over total assets, the greater the provision set by commercial banks. This situation may be indicating that the comfortable level of capitalization presented by the banks in Brazil (23.20% of total assets, on average) is inducing an increase in the provision level whenever net equity presents a positive variation, which represents a conservative procedure that also serves as a counterpoint to setting pro-cyclical provisions. In Spain, the “net equity over total assets” variable was not found to be significant, indicating that the provision level is not affected by the behavior of the equity of commercial banks that operate in that country.

The “size” variable was found to be statistically significant only in relation to the banks that operate in Spain. In the other countries, the size of the banks does not appear to influence the provision level.

The results support the previous studies by Bikker and Hu (2002Bikker, J. A., & Hu, H. (2002). Cyclical patterns in profits, provisioning and lending of banks and procyclicality of the new basel capital requirements. Banca Nazionale del Lavaro Quarterly Review, 55(221), 143-175. Retrieved from https://www.dnb.nl/binaries/ot039_tcm46-146052.pdf.
https://www.dnb.nl/binaries/ot039_tcm46-...
), Laeven and Majnoni (2003Laeven, L., & Majnoni, G. (2003, April). Loan loss provisioning and economic slowdowns: too much, too late? Journal of Financial Intermediation, 12(2), 178-197. Retrieved from http://www.sciencedirect.com/science/article/pii/S1042957303000160.
http://www.sciencedirect.com/science/art...
), and Bikker and Metzemakers (2004Silva, C. A. M. (2016). Utilização da provisão para créditos de liquidação duvidosa para fins de gerenciamento de resultado nas instituições financeiras brasileiras e luso-espanholas (Master’s thesis). Faculdade de Economia, Administração e Contabilidade, Universidade de Brasília, Brasília, DF.), in the sense that the provision behavior strongly depends on the economic cycle, indicating that the provision generally grows in poor economic times. Another similarity between the results of this research and the aforementioned studies is the finding that the effect of pro-cyclicality is usually mitigated by an increase in the provision in periods of higher earnings (earnings management practices).

A possible assumption regarding the fact that the research revealed pro-cyclical behavior when countercyclical behavior was expected is that the banks may be using discretion and managing their earnings via the provision and more than compensating for the expected effect of the models, which is a hypothesis to be investigated in future studies.

It was also found that in Brazil and the United Kingdom the effect of economic variations on the provision behavior takes place in the same accounting period. In the case of Spain, however, a variation in GDP in the previous period was found to be a significant variable.

With relation to the econometric model chosen for the research, it was found that the peculiar nature of the provision rules in the United Kingdom, in relation to those in Brazil and Spain, may be determining the difference in the levels of significance of the explanatory variables for the model, when this is applied to commercial banks in the country that adopts the IASB accounting standards. Thus, it is assumed that adaptations are needed to adjust the model used to the specificities of countries that use relatively different accounting rules for setting the provision.

As an intentional sample is concerned, which considers only one country for each accounting model, the results may not be generalized. For future research, studies with different econometric models are suggested, incorporating variables not considered in this research, especially those related to the delay in the payment of principal and interest and to the accounting recognition of losses. Evaluating the question of cyclicality by considering different accounting scenarios in the same country (for example, studying cyclicality before and after the advent of Resolution n. 2,682/1999) could also prove to be an interesting experiment for reflecting on the provision behavior in different regulatory environments.

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Publication Dates

  • Publication in this collection
    06 Nov 2017
  • Date of issue
    Jan-Apr 2018

History

  • Received
    11 Oct 2016
  • Accepted
    08 Aug 2017
Universidade de São Paulo, Faculdade de Economia, Administração e Contabilidade, Departamento de Contabilidade e Atuária Av. Prof. Luciano Gualberto, 908 - prédio 3 - sala 118, 05508 - 010 São Paulo - SP - Brasil, Tel.: (55 11) 2648-6320, Tel.: (55 11) 2648-6321, Fax: (55 11) 3813-0120 - São Paulo - SP - Brazil
E-mail: recont@usp.br