Questions To Ask Your Banker, Central Banker or your Professor
Why should banks be required to set aside provisions for risks they cannot estimate accurately?
Why should banks set aside large provisions after collecting high-quality collateral from potentially risky borrowers?
When expected losses for which provisions were made do not materialize, what do banks do with these provisions? Don't tell us that banks just keep them as reserves. That's theoretically accurate according to financial accounting theory but the non-accounting person do not want this answer. So, what do bank do with provisions?
Also, during a recession, banks would normally require high-quality collateral in exchange for loans and still increase overall provisions, perhaps, due to adverse selection and moral hazard issues. These practices provide evidence of too much prudence in banks' credit risk function. This brings us to the question: how much provisioning is too much? Is over-prudence a good thing?
Why do banks set-aside provisions?
The simple answer is that banks are being cautious, careful and proactive about loan loss and therefore, set aside some amount of money to cover for credit losses on bank loans. In the event of failure to repay loan by the debtor or group of debtors, the bank can recover the loan looses from provisions.
Bank Regulators wants over-prudence.
The good thing about over-prudence is if it accurately estimates credit losses on the loan portfolio. However, we know that this is not usually the case in banks. Academics know this, as well. The bad thing about over-prudence is that it often over-estimates credit losses.
Over-prudence: Bank Regulators vs Medical Doctors
Just as medical doctors know that excessive dosage of a particular drug prescription do not make a patient any better and might lead to unintended health consequences, bank regulators do not understand that over-prudence or over-regulation do not make banks any better, rather, it motivates banks to engage in behaviours that may lead to unintended regulatory consequences, for example, income smoothing, capital management, etc. Following this reasoning, too much prudence may not be a good thing because while it solves one problem, but creates another problem - leading to unintended consequences. Regulators should find the exact amount of provisions that optimally measures credit loss
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