Dynamic Provisioning: A Buffer Rather Than a Countercyclical Tool?

The global financial storm that started in 2007 is one of the very best examples in recent economic history of how much the financial system can exacerbate real economic cycles. This procyclicality has triggered a lively debate on which tools can be used to smooth the pattern, with a focus on macroprudential policies.

There was limited experience in the use of macroprudential instruments before the crisis. The most prominent examples are the use of loan-to-value (LTV) ratios in some Asian countries and dynamic provisions in Spain.¹ The latter received a lot of attention and in the early stages of the crisis were seen as a model for the then-incipient international regulatory reform.

The debate shifted rapidly from provisions to capital, and the reform soon crystallized in the adoption of a capital buffer in the context of the Basel III Accord.² The discussion on provisions languished and is now in a deadlock. Two reasons explain this declining interest: the difficulties for accounting harmonization between the Americans and the Europeans, which partly explains why the Basel Committee took the easier route of capital; and the evidence, as the crisis deepened, that dynamic provisions did not prevent serious problems in certain segments of the Spanish banking system.³

The analysis of the Spanish case raises several complex issues. Why was dynamic provisioning insufficient to protect the banking system in the wake of the crisis? Was it a problem of design or application? Or were the bubble and the crisis too big to be addressed by this tool? Did dynamic provisioning have unintended consequences? In particular, did it delay the solution of the problems of savings banks? Was it a useful buffer, but not a genuine countercyclical tool?

This paper focuses in the latter issue, but all the questions are very much interlinked. The question of whether dynamic provisioning was a buffer or a dampener is closely related to the debate on rules versus discretion. Under a formula-driven system, the required level of provisions would vary according to some predetermined metric. It would provide a preset discipline independent of judgment, but its success will depend crucially on the possibility of calibrating the business cycle ex ante. A rules-based system is superior to a discretionary mechanism in situations where the policymaker lacks credibility of commitment.

However, a rules-based system may face constraints that ultimately lead to discretionary adjustments. In particular, asymmetric market discipline (that is, the fact that markets are too lenient in good times and too strict in bad times) may preclude the use of the accumulated buffer in the downturn, thus impeding the anticyclical compensation. We provide some evidence that this was a factor in the case of Spain: when liquidity dried up and funding in the interbank market disappeared, markets required a higher level of own funds, limiting the anticyclical impact of dynamic provisions. To be fair, the sheer size of the crisis also limited the compensation of rising nonperforming loans (NPLs), with the final effect that total provisions rose considerably in the bust, contrary to what was intended.

Spain is not the only country that adopted dynamic provisions, but it was the pioneer and it is the only system for which there is experience on a boom-and-bust cycle. To obtain more general conclusions, we compare the Spanish case with two Latin American countries that adopted dynamic provisions in the late 2000s: Colombia and Peru. The comparison with these countries supports more general conclusions on the pros and cons of alternative designs and provides insight into whether particular aspects need to be taken into account in applying this tool to emerging market economies.⁴

Literature Review

There are many reasons for the procyclicality of the financial system. A quick review is warranted to better understand which instruments could be most efficient for limiting it.

First, the financial system is prone to having a more lax assessment of risk in good times than in bad ones, influenced by the economy’s general environment. The idea of shortsightedness...