# **_General Considerations about Provisioning_**

The provisioning approaches discussed above all represent some improvement over the incurred loss model, and the underlying concept is all expected losses. The exact formula and calibration may differ across countries, but there are basic requirements on loan loss data for any system. Although some approaches discussed may rely on or allow for the use of internal models, for most of developing countries, a model designed and calibrated by the regulator is probably needed due to widespread data constraints. A supervisory model also provides the added benefits in terms of competitive equality and discipline of the management. Countries with centralized credit registry may have an advantage in implementing such a system.

Another important consideration in designing a provisioning regime is the transparency of design and disclosure. There are concerns about income smoothing and capital management if too much management discretion is allowed in provisioning.<sup>31</sup> A prescriptive rule-based system certainly reduces the scope of management discretion, but depending on its design, it may not be able to distinguish different levels of credit risk in the portfolios of individual banks. This means that the design of a countercyclical provisioning regime should be transparent and the disclosure should at minimum distinguish between the countercyclical component and the provision for losses that have been individually identified.

A related issue is whether expected losses should be covered through countercyclical provisions or reserves. Provisions are charged as an expense on the income statement of a bank and affect earnings. On the balance sheet, the accumulated provisions act as an offsetting account to gross loans. With expected loss provisioning, this can still be the way of presenting financial statements. However, as a countercyclical objective is included in provisioning, a question arises from a nonregulatory perspective whether it is appropriate to present provisions (and thus earnings) that are smoothed out over a certain period as opposed to presenting the current state of affairs. A potential alternative is to cover the countercyclical component of expected losses using reserves:<sup>32</sup> that is, through transfers from retained earnings or segregation of other components of equity capital on the balance sheet. The main difference between these two approaches is that the former has a direct impact on the earnings of a bank on the income statement, while the latter does not, but only places a constraint on distributable earnings. One benefit of using reserves is that it affords some flexibility to the regulators and provides an easy way of reconciling conflicting regulatory and accounting objectives instead of requiring two sets of accounts. However, with the issue discussed in the previous paragraph as a caveat, there are strong arguments for countercyclical provisions to run through the income statement in order to mitigate the undue volatility of earnings through the cycle (and the biased incentives that come

> 31 There is a literature on management discretion in loan loss provisioning. For empirical studies on provisioning and income smoothing and/or capital management, see Cavallo and Majnoni (2001); Soares de Pinho and Carvalho Martins (2008); and Floro (2010).

> 32 For a discussion on provision versus reserving, see FEE (2010).

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