Measuring loan-loss provisions: ‘lend now, lose later’

The early provisioning of loans is of great practical importance. If the interest income earned on the loan at the end of the first year were considered as profit, there would be great incentives for lenders to make high-margin (and often high-risk) loans with a long maturity with the objective of showing a strong profit in the early years. If this lending strategy was good for the performance and the bonus of the loan manager at the end of the year, it could hurt the bank in the future when loan losses show up. To reduce the incentive for high-margin, high-risk lending, banks need to create early dynamic provisions.

To calculate fair loan-loss provisions, we simply observe that, after the ...

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