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Credit Smoothing and Determinants of Loan Loss Reserves. Evidence from Europe, US, Asia and Africa

Ozili, Peterson K (2015): Credit Smoothing and Determinants of Loan Loss Reserves. Evidence from Europe, US, Asia and Africa.

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This study provides a link between accounting, managerial discretion and monetary policy. Monetary authorities encourage banking institutions to supply credit to the economy. Increased bank supply of credit is a good thing but too much of a good can be a bad thing. This paper investigates under what circumstances excessive loan supply ceases to be a good thing and how bank managers react to this. After examining 82 bank samples, I find that (i) bank underestimate the level of reserves to boost credit supply in line with expectations of monetary authorities, particularly, in Asia and UK (ii) consistent with the credit smoothing hypothesis, US and Chinese banks smooth credit supply to minimize unintended stock market signaling; (iii) managerial priority during a recession is to smooth credit over time rather than to boost credit supply; (iv) non-performing loans, bank portfolio risk and loan portfolio size are significant determinants of the level of loan loss reserves; and (v) credit risk, proxy by loan growth, do not have a significant impact on loan loss reserves but tend to have some significant effect during a recession, particularly, when change in loans is negative. The implications of these findings are two-fold: (i) bank managers use their discretion over reserves to influence bank credit supply; (ii) bank supply of credit is not solely driven by loan demand but by a combination of several factors, particularly, capital market concerns, the need to avoid scrutiny from monetary authorities, and country-specific factors.

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