In addition to the practical issues I have mentioned, behind dynamic provisioning there lied a conviction, resulting from many years of supervisory experience and, more recently, also from empirical evidence, that credit risk appears in bank balance sheets at the time lending is granted. Risk is an ex ante concept, and default is no more than the ex post manifestation of this credit risk. As I just mentioned, banks commit lending policy errors in upturns, when there is excessive optimism and it is believed that the business cycle has disappeared and that recessions are a relic of the past that will not return, and when bankers, caught up in this wave of exuberance, relax their credit granting standards. By contrast, and as we are all experiencing at the moment, a reaction in the opposite direction occurs in recessionary phases. Banks, pressured by high default rates, which impact their income statement and their level of capital, contract credit significantly, granting financing only to those borrowers whose solvency is beyond all doubt. The end result is as follows: an overly expansionary credit cycle during the upswing and, by contrast, overly contractionary credit growth during the downswing. In addition, there may be a perverse effect on institutions’ income statements and levels of capital. During upswings, the failure to recognise risk through loan loss provisions results in very high profits.
But a more conservative monetary policy in expansionary phases would not only have favourable effects on tempering the amount of credit, it would also improve credit quality. Monetary policy also affects how banks assume risks. Researchers at the Bank of Spain have shown that a long period of low interest rates contributes to relaxing banks' credit granting standards. The market pressure to maintain high returns in a setting of low interest rates and, therefore, of lending offering very tight income margins, leads some banks to extend credit to individuals and firms with a greater risk profile. Also, the expansionary monetary policy stance means this greater risk takes longer to materialize, which in turn stimulates ever greater increases in this type of risky investment. Banks thus increase their risk profile by financing individuals and companies with a history of default, or by increasing the credit extended to new borrowers who, lacking a credit record, entail a greater level of uncertainty and, therefore, of potential risk to the bank. Finally, in an environment marked by low interest rates and the search by banks for yield, the general conditions of risk acceptance and selection are substantially relaxed, which translates into the riskier granting of credit that will materialise once the cycle turns down.