Counter-Cycle Provisions System.

Dear SAP Banking Community members.

As several studies have proved, the specific provisions and capital requirements regulation implemented for protecting the depositors of a bank from the default risk of the banking activity, produces some pain on the economic system due to its pro-cycle behavior.

As the economy moves to the recession phase of the economic cycle the Default Risk increases and with it the Capital Requirements and Provisions grow.

That of course, limits the resources available for offering new loans or refinancing contracts, and finally generates a “Credit Crunch”, which increases the damage on the economy.

In fact the whole process works as a vicious cycle in which increasing the default risk, limits the lending capacity of the Financial System, ending in a Credit Crunch which pushes the economy in a deeper recession.

As the economic situation becomes worse the Default Risk increases and also the required provisions, starting the cycle again.

With the discussions of the new regulation for the Financial System, one of the proposals under consideration is the introduction of “Counter-cycle” Provisions in addition to some modification on the Capital Requirements.

In my opinion, banking activity behaves with a clear pro-cycle pattern, especially regarding the quality of their assets. When the economy is doing well, bank’s clients pay on time their loans. On the contrary when the economy falls into recession banks have to recognize losses and make higher provisions.

On the other hand, during the expansion phase of the economic cycle, some Banks, driven by the objective of increasing their market share, can make risky investments which will be the source of future losses.

The pro-cycle behavior of the provisions obeys to the risk perception itself.

The common view is that the risk is a consequence of the recession cycle, when the clients start to fail on their payment obligations. In my opinion a more realistic thinking should consider that the risk is a component of the Banking activity and it exists during the two phases of the cycle, but unfortunately it’s much more visible on the recession phase.

The basic description of a counter-cycle provisions model would work according to the following pattern:

- During the expansion phase of the economic cycle, when the “specific” provisions are small, the “generic” counter-cycle provisions should be high, recognizing the difference between the expected losses through the full economic cycle and the “specific” provisions of every year.

- During the recession phase, when the specific provisions are high, the bank will use the resources stored by the “generic” provisions during the expansion phase, limiting the credit crunch described at the beginning of this post.

Finally I think that the implementation of a counter-cycle provision model requires an integrated Risk and Capital Management System which permits the analysis of the origin of the risk during the whole economic cycle.

The described system should offer sophisticated reporting tools for supporting the bank managers on the evaluation and tracking of the provisions generation during the whole economic cycle; and specially how the resources stored by the generic provisions are utilized later by the specific provisions.

Looking forward to read your opinions.

Cheers.

Ferran.