Relationship Between Loan Loss Provision And Capital Adequacy Ratio

Commercial banks play a key role in the economic life and therefore, are strictly regulated. Loan loss reserve system and the level of capital adequacy ratio of commercial bank are two important components of supervision. Loan loss reserve, as a major part of operating costs, covers expected loan losses while capital are usually used to absorb unexpected losses. The amount of loan loss reserves in China are mainly regulated by three regulatory bodies, namely Ministry of Finance, China Banking Regulatory Commission and the central bank. As the first pillar of "New Basel Accord", the Basel Committee explicitly pointed out that capital adequacy ratio must be based on full provision for loan losses. In the paper followed, the author is trying to find out the relationship between loan loss reserve and the level of capital adequacy ratio.This paper is divided into six parts. In the first part, the author introduces the general idea of the paper, the background based and the structure of the paper. The second part is a literature review and background introduction.In the third part, the author analyzes the relationship among capital bases, loan loss provisions and the level of capital adequacy ratio from two angles. From an accounting point of view, the author believes that, through the link of net profit, loan loss provisions are negatively related to capital bases. From a view of risk management, the author finds out that a high level of loan loss provision helps to avoid erosion of bank's own capital.The fourth part describes China's current laws and regulations on loan loss provisions and capital management. Besides, the author makes a comparison between China's a loan loss data and the world's as a whole.In the fifth part, the author conducts descriptive analysis based on data from four commercial banks, namely Merchants Bank, Shanghai Pudong Development Bank, Minsheng Bank and Shenzhen Development Bank. The analysis focuses on the rate of change and the absolute value of the four bank's data, trying to verify the relationship derived from the third part of this paper.After a short summary of the five parts above, the author makes recommendations from the viewpoint of banking regulators and banking practitioners. From the view of banking practitioners, four recommendations are made as following: a risk-based performance evaluation system should be set up; professionals are in great need; the structure of commercial banks'income should be diversified and importance should be attached to operational risks. From the point of banking regulators, the author put forward three suggestions:laws and regulations regarding loan loss provision shall be clearly stated; system of risk evaluation shall be further improved and a dynamic loan loss provision mechanism may be appropriate.