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Mumbai , Nov. 17

THE annual loan loss provisioning for 75 domestic banks (27 public sector banks, 8 new private, 20 private and 20 foreign banks) for the 1997-2003 period, indicates "that loan loss provisions tend to display a downward movement during the period when the gross domestic product (GDP) growth is high".

It is widely perceived that risk-based minimum capital requirements tend to have a counter-cyclical effect on the economy. After all, during an economic downturn, the quality of the bank loan portfolio deteriorates, which leads to an increase in capital requirements for provisioning of such loans, according to a RBI report.

Apparently, banks tend to show "imprudent loan loss behaviour" and are susceptible to pro-cyclical effect on their capital, if one of the following three conditions are met: a) loan loss provisions are negatively associated with banks' earnings (i.e., if a bank is prudent in smoothing income, it should keep aside high provisions during periods of better earnings); b) loan loss provisions are negatively related to loan growth (i.e., rapid growth of bank lending is associated with deterioration in the quality of the loan portfolio); c) loan loss provisions are negatively related to GDP growth, to address its relationship with the economic cycle.

There are several policy implications for such observed behaviour of domestic banks, the report said.

First, there is a policy incentive to encourage banks to make sufficient provisioning to take care of exigencies. The Union Budget 2002-03 had raised the allowance for deduction by banks against provisions made for bad and doubtful debts from 5 per cent of total income to 7.5 per cent.

Secondly, it might be desirable to set aside more resources during periods of economic growth than during downturns. This pattern of general provisions is labelled as `dynamic provisioning'. The fundamental principle underpinning such provisioning is that provisions are set against loans outstanding in each accounting time period in line with an estimate of expected long-run loss.

In India, provisions towards bad loans constitute around 10 per cent to 12 per cent of total expenses of scheduled commercial banks, but there is a marked variation across banks, with State-run banks generally provisioning higher in absolute terms than foreign banks.

In 2002-03, all bank groups and public sector banks in particular, witnessed sharp increase in provisions and especially in loan loss provisions, both in percentage terms and also as a ratio to total expenses.

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