Effect of the basel accord capital requirements on the loan-loss provisioning practices of Australian banks

There are two distinct regimes for bank provisioning in Australia: a forward-looking model for regulatory purposes and an incurred loss model for financial reporting. This study examines the former using a unique but confidential database. We find evidence that: (i) regulatory provisions reflect the default risk of banks’ loan portfolios, (ii) banks allocate part of surplus capital above Basel minimum requirements to pre-fund future credit losses through provisions (which holds for banks using either external or internal ratings-based approaches), and (iii) banks allocate part of higher earnings for the same purpose. These findings suggest that bank managers use their discretion in setting provisions to dampen the impact of fluctuations in credit market conditions on their lending activities