Loan Loss Provisioning Practices in Hong Kong Banking Sector

In the wake of Global Financial Crisis 2008/2009, much attention has been placed on the pro-cyclicality of the banking system and the ability of the banks to absorb economic shocks; questions have been raised about the quality of the banks’ credit portfolios and the rigidness of the provisioning system. Whilst the current debate on the pro-cyclicality of the banking system has focused on the pro-cyclical effects of Basel II Capital Accord, little attention has been placed on the pro-cyclicality created by the provisioning system. The purpose of this paper is to study the loan loss provisioning practices in Hong Kong banking sector during 2005-2011. This paper seeks to first investigate how the provisioning behaviour of the commercial banks in Hong Kong is related to the business cycle, and then to find out whether the bank managers in Hong Kong use their discretion on loan loss provisions for capital management and earnings management. Based on a final sample of 23 commercial banks in Hong Kong and controlling for unobservable heterogeneity and endogeneity of explanatory variables, the results reveal that pro-cyclical loan loss provisioning has dominated in Hong Kong; provisioning tends to be higher during the economic downturns and lower during the economic expansions. Empirical results also show a negative relation between the capital equity ratio and loan loss provisions, suggesting that bank managers in Hong Kong use loan loss provisions to manage their capital. Conversely, the results do not support for the earnings management hypothesis; there is no significant positive correlation between the earnings of the banks and the loan loss provisions, meaning that the bank managers do not provision at the time when the earnings is high. Keywords: loan loss provision, Hong Kong commercial banks, pro-cyclicality, discretio