Does Provisioning based on Expected Credit Losses Weaken Risk-taking Discipline?
One important concern about the recently introduced standards to account for loan loss
provisions is the possibility that the new approach –which is based on expected (rather than
incurred) credit losses–weakens bank discipline by allowing for more managerial discretion.
Exploiting the recent introduction of IFRS 9 across the world, we reach the opposite
conclusion; the new approach appears to limit the opportunistic delay of credit losses. We
first observe that the entry-into-force of IFRS 9 is followed by a dramatic decrease in
discretionary smoothing (which prior literature finds to dampen discipline over risk-taking).
Consistently, we find a remarkable and robust increase in risk-taking discipline among banks
exhibiting higher discretionary smoothing before the implementation of the new standard.
This pattern is stronger among banks with more discretionary and less timely provisions, and
more incentives to manage earnings. Our results are also more pronounced when the bank is
subject to tighter enforcement.