On bank loan losses and ways to account for them

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JANE FULLER

News

Nicolas Véron, senior fellow at Bruegel, in Brussels, and at the Peterson Institute for International Economics in Washington DC, recently published a blog as an antidote to bank lobbying to relax both accounting standards and capital requirements:

Véron argued that regulators “should ignore the bankers’ admonishments. There is no perfect accounting thermometer for credit risk in banks’ loan books but breaking the current thermometer in the midst of a crisis would do more harm than good.”

The accounting standards in question are IFRS 9 (in force for the past couple of years in Europe and elsewhere) and ASU 2016-13, which is only just being implemented in the US. The new standards work on an expected credit loss model. Some losses are provided for at inception, and there is more timely recognition of worsening expected losses – triggered if credit risk increases significantly.

As Véron points out, banks were never enthusiastic about having to book losses earlier. The important point he stresses is that other regulatory reforms, notably Basel III, have forced banks to build up capital buffers, which can now serve their purpose of absorbing recession-induced losses. I agree with him.

The actions taken in the past few days by regulators, forcing (or leaning on) banks to suspend dividends and share buybacks and cut cash bonuses, will further bolster capital. They seem to be leaning towards the robust view on capital conservation provided by Sheila Bair, former chair of the US Federal Deposit Insurance Corporation, in a Financial Times article (March 22), headed: “Force global banks to suspend bonuses and payouts” .

IFRS 9

For those of you stuck at home with nothing better to do than read about accounting and bank capital requirements, here are some further thoughts on IFRS 9. (Several CRUF members contributed to the development of IFRS 9 via the IASB’s Capital Markets Advisory Committee and responses to consultations.)

This standard (among other things) has reformed the way banks measure loans and account for defaults. It is anchored in the reaction to the great financial crisis (GFC) – notably addressing “concerns of the G20 and others about the delayed recognition of credit losses”.

Instead of assuming that loans are fine until they are as dead as parrots (the incurred loss model), banks must switch into forward-looking mode and provide for expected credit losses (ECL). Spanish banks kept to a version of this, called dynamic provisioning, before the GFC and at least they went into it with some “losses” in hand. Another effect is to take the froth off interest income in the good times.

The trouble with the forward-looking approach is that it involves modelling, using probability weightings and feeding in economic assumptions. What pops out is supposed to be a reliable as well as a relevant measure. IFRS 9 is not too ambitious with the crystal ball – the ECL allowance looks ahead at the probability of default over the next 12 months. The US version says look at the full life of the loan. Yes, that does entail higher upfront provisions for losses, which helps to explain the louder squealing in the US. 

The transition from lagging provisions to forward-looking ones entails an overlap that can cause a hump of losses. In a speech in 2015, Hans Hoogervorst, chair of the International Accounting Standards Board (IASB), said: “First indications are that this model will lead to a very substantial increase in the level of provisioning, in the order of around 35 per cent.”

Hence transition arrangements, allowing phase-in over about three years. With the US still in the early stages of implementation, calls for a delay have been heeded in the $2 trillion stimulus package, which covers the emergency period – potentially to the end of this year. Regulators have also given banks an option to further delay the impact on regulatory capital. 

Optional behaviour is never popular with those who analyse accounts because it makes it difficult to compare companies. Analysts also worry about whether the information they receive actually reflects economic reality, especially for those highly cyclical companies called banks.

Under IFRS 9, the big question after booking the initial loss allowance, is what to do when credit risk increases “significantly”. If a payment is overdue by more than 30 days, history tells banks that there is a significant increase in the 12-month probability of default. And the way you then account for expected losses is to asses them over the full life of the loan. 

With a rearview mirror focused on banks delaying the recognition of losses, the 30-day trigger was made a “rebuttable” assumption. You can, however, rebut it if you have “reasonable and supportable information”. Bearing in mind that a pandemic shutting down swathes of business was beyond the imagination of standard-setters, policy-makers and almost everyone else in the years following the GFC, we are deep into “rebut” territory. 

As the IASB says in a note (March 27) on IFRS 9 and COVID-19, the standard “does not set bright lines or a mechanistic approach to determining when lifetime losses are required to be recognised”. 

What the central banks say

Central banks have been quick to point to the scope for judgment. Sam Woods, Deputy Governor of the Bank of England and head of the Prudential Regulation Authority, wrote the following ‘dear CEO’ letter to banks on March 26: 

On IFRS 9, he stresses that measurement of ECL should be implemented “on the basis of the most robust reasonable and supportable assumptions possible in the current environment”. To reduce the risk “that a significant overstatement of ECL could prompt behaviour that leads to unnecessary tightening in credit conditions”, he lists some mitigating factors. These include unprecedented levels of government and central bank support and giving due weight to established long-term economic trends. 

Woods reckons that “while the reduction in activity associated with Covid-19 could be sharp and large, it is likely to rebound sharply when social distancing measures are lifted”. On this basis, many borrowers needing support measures in the short-term will not suffer a deterioration in their lifetime probability of default. 

Whisper it softly but he is singing from the same hymn-sheet as the European Central Bank (ECB). The UK regulator has followed the ECB in imposing dividend suspensions but has gone further on pay. Read the PRA statement on deposit takers’ approach to dividend payments, share buybacks and cash bonuses in response to Covid-19.

As Véron points out, the most important aspect of preparation for additional loan defaults when the economy tanks is the level of loss-absorbing capital that banks have built up since the GFC. The ECB estimates that allowing eurozone banks to run down buffers built on top of the minimum requirement will release up to €120bn of equity capital. This could “potentially finance up to €1.8 trillion of loans to households, small businesses and corporate customers in need of extra liquidity”.

While we could all be overwhelmed by either the disease or the business-sapping measures that are combatting it, both accounting and prudential regulation should be allowed to work as intended. The first provides some timely transparency on the financial performance and financial soundness of banks. The second should ensure that those institutions can absorb the inevitable ups and downs of real life. 

But this is just measurement, with all its attendant uncertainty – especially about the future. Whatever numbers pop out should better inform policy makers, regulators and investors, but they are the ones with the power to act.

This is an adapted version of a blog published by the Centre for the Study of Financial Innovation, where Jane Fuller is co-director. 

Jane is a CRUF UK Participant, fellow of CFA UK and a former chair of its financial reporting and analysis committee. She served on the CMAC at the IASB, 2007-14. Previously, she was financial editor of the Financial Times

Disclaimer: 

The views expressed in the blog are those of the author and do not necessarily represent the views of all CRUF participants. To read more about the CRUF’s views on this and other topics, please visit the comment letters section of the CRUF website.’

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