Saving on a Rainy Day? Income Smoothing and Procyclicality of Loan‐Loss Provisions in Central European Banks

Abstract

Abstract This paper analyses income smoothing and cyclicality of loan‐loss provisions (LLP) in Central European banks. I provide strong empirical evidence that banks in the region use loan‐loss provisions to smooth their income streams, and that these provisions are procyclical with respect to national business cycles. In addition, I find that income smoothing may only partly be explained through the concept of ‘saving for a rainy day’. Banks do use periods of high earnings to smooth income, but they also elect to build further reserves during periods of heavy losses—that is, on the ‘rainy days’ themselves. This behaviour deepens existing losses and may obscure the bank's underlying profitability. Introducing regulatory measures in line with the Bank of Spain's dynamic provisioning system would make income smoothing in Central European banks more transparent and could limit the scope for discretionary provisioning during periods of low profitability.

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