How does monetary policy shock affect banks' loan loss provisioning behavior? Evidence from Chinese commercial banks

Abstract

This study examines the impact of monetary policy shocks on banks' loan loss provisioning behavior using panel data from Chinese commercial banks. We find robust evidence that a positive monetary policy shock negatively affects banks' loan loss provisions (LLPs), as banks adjust LLPs to enhance reported earnings and conceal risks during periods of monetary tightening. Further analysis reveals that banks with higher risk profiles or weaker risk resilience exhibit larger reductions in LLPs in response to monetary policy shocks. Additionally, stricter macroprudential policies and higher regulatory quality encourage banks to maintain higher levels of LLPs. We also find that during periods of credit contraction, banks are less likely to reduce LLPs to bolster future earnings, as doing so poses greater risks. The findings underscore the importance of maintaining transparent and stable monetary policy to prevent distortions in banks' loan loss provisioning behavior and highlight the need for effective regulations to ensure that banks remain healthy and maintain adequate LLPs, particularly during economic and financial downturns.