Banks' Procyclical Behavior: Does Provisioning Matter?

A panel of 186 European banks is used for the period 1992-2004 to determine if banking behaviors, induced by the capital adequacy constraint and the provisioning system, amplify credit fluctuations. Our nding is consistent with the bank capital channel hypothesis, which means that poorly capitalized banks constrained to expand credit. We also find that loan loss provisions (LLP) made in order to cover identified credit losses (non discretionary LLP) amplify credit fluctuations. Indeed, non discretionary LLP evolve cyclically. This leads to misevaluation of expected credit risk which affect banks'incentives grant new loans since lending costs are misstated. By contrast, LLP used for management objectives discretionary LLP) do not affect credit fluctuations. The findings of our research are consistent with the call for the implementation of a dynamic provisioning system in Europe.