Dynamic provisioning, also called forward looking loss provisioning, is the adjustment of banks provisions for defaults on loans for the effects of the economic cycle, so that provisions will be increased during booms, to leave for the possibility or a downturn, and provisions will be lower during a recession, as there is less room for worsening.
Reducing provisions during a downturn also prevents confidence in the stability of banks being undermined by weak, and sometimes rapidly weakening, balance sheets.
The most influential example of dynamic provisioning to date has been that imposed on Spanish banks during the credit crunch. This used the following formula:
g = αΔC + (β - s/C)C
Where g is general provisions,
α is a fraction that adjusts for new loans (which would not have specific provisions yet),
C is the size of the loan book, ΔC is the change in C (positive means increasing),
β is the average specific provision over the economic cycle,
s is total specific provisions,
A specific provision is the loss a bank expects to make on a particular loan, and is made only when there is sufficient reason to make a provision for that load.
The effect of enforcing general provisions by this formula is to smooth the total level of provisions. The second term, (β - s/C)C, sets the level of general provisions so the total provisions are what they would be at the average of the cycle: i.e. general provisions would be zero at at perfect mid-point of the cycle.
The first term, αΔC, adds a further adjustment for credit expansion so that new risk (when credit is expanding) and risks taken off the books (when credit is shrinking) are taken into account.
The formula is applied separately to assets in different risk buckets, similar to those used for risk weighted assets.
Spain's introduction of this system during a severe banking crisis as rather too late, in that it missed the major benefit of dynamic provisioning, the extra provision made when the economy is strong and credit expanding. Other countries are following in similar, if less pressing circumstances. No doubt, the next sustained boom will gives the banks a chance to lobby for dynamic provisioning to be abolished lest it slow down the economy by restricting credit.
There has been considerable conflict between accounting standards bodies and banking regulators over the desirability of dynamic provisioning. Accountants (and their regulators) want to measure performance as it is at the moment, banking regulators want to use accounting metrics to force prudence on the banks. Investors need to treat both warily and make their own assessments of risk.