Loan Loss Provisioning Rules, Procyclicality, and Financial Volatility

Interactions between loan-loss provisioning regimes and business cycle fluctuations are studied in a dynamic stochastic general equilibrium model with credit market imperfections. With a backward-looking provisioning system, provisions are triggered by past due payments. With a forward-looking system, both past due payments and expected losses over the whole business cycle are accounted for, and provisions are smoothed over the cycle. Numerical experiments with a parameterized version of the model show that a forward-looking regime can be highly effective in mitigating procyclicality of the financial system. The results also indicate that a credit gap-augmented Taylor rule, coupled with a forward-looking provisioning system, may be the most effective way to mitigate real and financial volatility associated with financial shocks.