Dynamic provisions could help to enhance the solvency of individual banks and reduce procyclicality. Accomplishing these objectives depends on country-specific features of the banking system, business practices, and the calibration of the dynamic provisions scheme. In the case of Chile, a simulation analysis suggests Spanish dynamic provisions would improve banks’ resilience to adverse shocks but would not reduce procyclicality. To address the latter, other countercyclical measures should be considered. It has long been acknowledged that procyclicality could pose risks to financial stability as noted by the academic and policy discussion centered on Basel II, accounting practices, and financial globalization.1 Recently, much attention has been focused on regulatory dynamic provisions (or statistical provisions). Under dynamic provisions, as banks build up their loan portfolio during an economic expansion, they should set aside provisions against future losses.2The use of dynamic provisions raises two questions bearing on financial stability. First, do dynamic provisions reduce insolvency risk? Second, do dynamic provisions reduce procyclicality? In theory, the answer is yes to both questions. Provided loss estimates are roughly accurate, bank solvency is enhanced since buffers are built in advance ahead of the realization of large losses. Regulatory dynamic provisions could also discourage too rapid credit growth during the expansionary phase of the cycle, as it helps prevent relaxation of provisioning practices.
However, when real data is brought to bear on the questions above the answers could diverge from what the theory implies. This paper attempts to answer these questions in the specific case of Chile. It finds that the adoption of dynamic provisions could help to enhance bank solvency but it would not help to reduce procyclicality. The successful implementation of dynamic provisions, however, requires a careful calibration to match or exceed current provisioning practices, and it is worth noting that reliance on past data could lead to a false sense of security as loan losses are fat-tail events. Finally, since dynamic provisions may not be sufficient to counter procyclicality alternative measures should be considered, such as the proposed countercyclical capital buffers in Basel III and the countercyclical provision rule Peru implemented in 2008. Below, section II explains the rationale for dynamic provisions concisely for the benefit of the reader unfamiliar with the literature. Section III describes the Spanish model. Section IV discusses the results of simulation analysis of the Spanish model calibrated to Chilean banks. Section V analyzes the joint dynamics of aggregate provisions and domestic credit. Section VI concludes. 1 Borio, Fur fine, and Lowe (2000) are among the first to discuss the interaction between procyclicality and financial stability; Brunnermeier et al (2010) provide a more recent discussion building on the experience of the 2008–09 crisis. Regulatory and accounting practices could contribute to procyclicality: see for instance Gordy and Howells (2006), and Plantain, Sapra, and Shin (2008); which may have been further exacerbated as the financial systems become globally integrated (Chan-Lau, 2008). 2 Dynamic provisions were first introduced in Spain in 2000 (Poveda, 2000, and Fernández de Lis, Martínez Pages, and Saurina, 2000).