Analyzing the Efficiency and Loan Loss Provisioning of the Banks in Hong Kong

This study examines the efficiency and determinants of loan loss provisions by using data from 19 commercial banks in Hong Kong over the period 2006-2011. Distinct from previous studies, we conduct a two-stage analysis, in the first stage X-efficiency is estimated and then included in the second stage for the estimation of determinants of loan loss provisions using system GMM estimation method. In particular, we examine the income smoothing and capital management hypothesis, the relationship between loan loss provisions and the business cycle (i.e. pro-cyclicality and counter-cyclicality) as well as the effect of X-efficiency on loan loss provisioning. Our findings demonstrate that Hong Kong banks exhibit income smoothing, however, the income smoothing effect is mitigated by the pro-cyclicality provisioning. Since Hong Kong implemented the IAS 39 in 2005, this backward looking provisioning guideline is accused as the cause of the pro-cyclicality provisioning. By including X-efficiency as one of the determinants, we control for the management effect on loan loss provisions, we find that Hong Kong banks manipulate earnings not for the purpose of smooth earnings, but for the prudent management, they set aside extra capital buffer for future loss. Moreover, there is sign of capital management by Hong Kong banks in which they manipulate the loan loss provisions for the purpose of maintaining stable dividend ratio and setting aside excess capital preparing for future loss as well as the increase of capital buffer under Basel III requirement. This prudent practice of Hong Kong banks is probably the result of tightened capital requirement by regulators (i.e. Basel, HKMA etc.) as well as the proposed expected loss approach in loan loss provisioning