Bank Loan Loss Provisioning: An Examination of Capital Management, Income Smoothing and Cyclicality Hypotheses

Abstract

Abstract. The changes in capital adequacy regulations may change the way bank managers ‘manage their capital and eamings. In 1991, loan loss reserves account was removed from Tier I capital and placed in the current category of Tier 2 capital. The new ruling limits the use of loan los reserves in meeting total capital requirement. In addition, the loan loss reserves must not exceed 1.25 per cent of risk weighted assets. Under the new rules, banks ith a regulatory capital ratio of less than the minimum requirement are subjected to Tegulatory pressure. Several studies indicate tht the regulatory pressure mofivates managers lo ngage in capital and camings management. With these regulation, te Basle minimum regulatory capital requirement is also said to behave pro-cyclical. When the economy is on down cycle, the capita level shrinks due to an increase in the amount of loan defaults. This Joan loss provisioning behaviour, however, has yet to be proven, thus creating the motivation to examine provisioning behaviour of Malaysian banks. In addition, this study 5 also motivated by the adaptation by Malaysia of te Basle 1988 capital regulation which does not put a cap on the level of loan loss reserves.