Financial shocks, loan loss provisions and macroeconomic stability

This paper studies the interactions between loan loss provisioning rules, business cycle fluctuations and monetary policy in a model with nominal price rigidities, a borrowing cost channel and endogenous risk of default. We show that an empirically relevant backward-looking provisioning rule induces financial accelerator mechanisms and results in financial, price and macroeconomic instability. Forward-looking provisioning systems, set to cover for expected losses over the whole business cycle, reduce significantly procyclicality in prices and output, and in addition moderate the (otherwise optimal) anti-inflationary response in the monetary policy rule. The optimal policy response to financial shocks calls for a combination of forward-looking provisions and a mildly credit augmented monetary policy rule.