Loan loss provision, unsecured-collateralized loan choice and macro-stability in China

We develop a novel dynamic stochastic general equilibrium model with loan-loss provisions (LLPs) and unsecured-collateralized loan choice, the latter being endogenously determined due to enterprises having heterogeneous production capacity. Further, due to the presence of a second source of production uncertainty, which is only observed ex-post to loan contracting, type-specific aggregate default rates are endogenously determined too, which results in a model economy whose cyclicality can be driven significantly by LLP adjustment shocks. We estimate the model using actual Chinese data from 2004Q4 to 2020Q4. Our estimated model is able to generate co-movement between LLPs and the unsecured-collateralized loan ratio, a feature of the Chinese banking system that is consistent with empirical evidence. We also find that banks' LLPs are countercyclical, despite the overall LLP regime still remaining relatively backwards-looking, indicating that the present Chinese banking regulations can be overly prudent.