A study to investigate the dynamic loan-loss provisioning method adopted by the Spanish banking system and the implications for the Spanish economy during the global financial crisis.

The recent global financial crisis has proven that procyclicality of loan loss provisions is an increasingly important issue, as banks underestimate credit risk and lower credit standards in good times, leading to under-provisioning and the need subsequent large increases in provisions in bad times. The issue of moral hazard exists within developed economies and throughout the global financial system, where central banks and state governments are known to be the ‘lender-of-last-resort’ for banks deemed globally systemically important financial institutions. This joint issue means that banks’ risk management processes, principally managing their credit risk, solvency and minimum capital requirements is of increasing importance to financial supervisors and regulators. The objective of this paper is to investigate the dynamic provisioning method within the Spanish banking system between the years 2006 to 2011 for the presence of income smoothing, procyclicality and capital management. The selection of such a time period is crucial, as it has allowed banks to build up loan loss reserves during the economic upturn from 2000 to 2006. The time period includes the subsequent down turn in the economy and any changes to provisioning methods as a result. Using 140 bank observations from a total of 34 commercial banks, dynamic panel regression using the system GMM method is used. The results confirm that both income smoothing and capital management were active during the time period selected, which confirms the hypotheses set out within this paper. For the riskiness of the bank, the risk proxy of gross loans (normalised by total assets) is positive and significant, which suggests that the riskier the bank the more they provision. The results of the macro-economic variables suggest there was no procyclicality during the period. As well as this, there is no link between Spanish banks provisioning and the annual change in house prices or the annual change in the central Government debt (as a % of GDP). This suggests a possible oversight by the Bank of Spain, who set accounting rules and control the models used for determining the amount of the statistical provision, to not include key macro-economic variables which may have indicated excessive credit growth, inflated asset prices and a need for higher provisioning and controls for these credit risk exposures