An Econometric Analysis of Efficiency and Loan Loss Provisioning Behaviour in German Banking

Abstract

This study examines the loan loss provisioning behaviour of the German banking industry by using a sample of 52 commercial banks over the period of 2007-2014. It investigates the relationship between loan loss provisions and the business cycle as well as the income smoothing and capital management hypotheses. In addition, the relationship between the bank’s loan loss provisioning behaviour and their efficiency is examined. This study conducts a two stage analysis: First, the efficiency levels of the banks are estimated from a translog cost function. Then, the estimated efficiency scores are incorporated into the regression of loan loss provisions using Generalized Method of Moments (GMM) estimators. It is found that German banks efficiency levels are relatively stable over the years and have an average of 91%. Moreover, the empirical findings from the GMM estimators provide evidence for the existence of procyclical provisioning behaviour and they support the capital management hypothesis, whereas the results do not indicate that German banks use loan loss provisions to smooth their income. Furthermore, this study finds a significant positive relationship between loan loss provisions and the banks efficiency levels