More banks are underprovided than are overprovided. This matters little when credit losses are low and expected to remain low. It becomes increasingly important, however, given a period of strong loan growth, when asset quality deteriorates, NPL levels start to rise and expected credit losses increase. The main reasons why banks may underprovide for expected credit losses are as follows:
Ignorance and industry practice. Many banks still operate on the implicit assumption that all loans will remain current and reach term. In effect they assume that expected losses on current loans are zero. Provisions for losses are then made only when a loan is actually identified as impaired. This may be because of a failure of management to understand the nature of expected losses or be due to a continuance of industry-level practices. Unrealistic expectations. Almost all project managers underestimate how long it will take to complete a project and how much it will cost. Even if bank management are trying to make realistic estimates of future credit losses these are likely to prove to be too low.
A rough rule of thumb applied to failed banks is that external auditor’s estimates of credit losses prior to closure will be double those of bank management. That the regulator’s initial estimates immediately after bank closure will be double that of the external auditors and that the final losses after liquidation will be double that of the regulator’s estimates. Maintaining depositor confidence. If the bad debt charge that should be made is so large that it pushes the bank into losses this may result in a loss of depositor confidence and result in a “run on the bank”. The main bank regulator will balance the systemic risks from such a bank run against the need for the bank to report realistic levels of expected losses. It is also likely to be mindful of the inevitable resulting blame allocation if a banking crisis resulted. At
such time they may well decide that as far as the public is concerned ignorance is bliss. Avoiding capital raising. Earlier recognition and higher estimates of expected credit losses may also result in the bank being unable to meet regulatory Tier I requirements because of the resultant reduction of its equity. Raising capital at such a time might be difficult to achieve at any price or result in a reduction in control of the controlling shareholders.
Collusion. As asset quality deteriorates the incentives to refuse to acknowledge expected credit losses increase. This refusal is not limited to bank management but extends to external auditors and is tolerated by bank regulators.