Regulatory Capital Ratios, Loan Loss Provisioning and ProCyclicality

Reducing lending allows banks concerned with future capital inadequacy to reduce the likelihood of a capital shortage. The capital crunch theory predicts that banks ’ lending is particularly sensitive to their regulatory capital ratios during recessions when regulatory capital tends to decline and external-financing frictions tend to increase. Pro-cyclicality in bank lending may be magnified when banks ’ loan loss provisioning is backward looking given the increase in loan defaults that occur during recessions. We find that, relative to banks with more forward looking loan loss provisioning, banks with less timely loan loss provisions reduce their lending more during recessionary relative to expansionary periods. We also find that loan loss provision timeliness reduces the capital crunch effect during recessionary periods. We would like to thank Daniel Benesh, Jere Francis and seminar participants at Indiana University and the University of Missouri for helpful comments. When banks face external-financing frictions, such as the adverse-selection problems modeled in Myers and Majluf (1984), they are not able to immediately restore reductions i