One of the major outcomes of the financial crisis was a fundamental review of how banks account for loan losses.
The new accounting standard, IFRS 9 Financial Instruments, will require banks to show their losses earlier than in the past. Overall, the losses themselves do not change in total over the life of the loans; only the timing of their recording by the bank will be different. The new approach is seen as more timely and it reflects the underlying economics more closely since expected future losses are already priced in the interest rate charged on the loans.
This is a complex area and it has taken time to make sure the new rules are fit for purpose. The financial services industry is devoting immense resources in preparation for the implementation from 1 January 2018.
The main activity of banks is to lend to people and businesses. When they do, the amount owed back to the bank is shown as an asset (a “debtor”) on the bank’s balance sheet: this is because it will be repaid to the bank at a later date. The bank charges interest on the loans, priced to reflect the risk of non-payment, as well as market rate of interest; this is shown in the profit and loss account as income.
Typically, the monthly amounts paid by the borrower include both capital and interest. The bank records this by reducing the amount owed by the customer (for the capital element) and showing the interest income in its profit and loss account.
In line with accounting rules, if the bank thinks that it will not recover the full amount of the loan, it has to reduce the asset in its financial statements and take a loss against it. For example, if a bank lends £100,000 but later thinks it will collect only £80,000, it must show a loss of £20,000 in its profit and loss account and show the net asset as £80,000.
This is accounting for lending in its simplest form. Of course banks have many types of loans, including mortgages, credit card balances and commercial loans.
Before IFRS 9, accounting rules forced banks to “wait” for a loss event before recording a loss against a loan asset. This was the case even when banks expected that a percentage of their loans would not be paid back in full. When the downturn came they had to catch up by recording significantly larger losses all at once. The result was the heavy criticism of banks during the financial crisis for providing “too little too late”.
After long discussions it was agreed that this was not helpful; losses should be booked when they are expected as well as when they actually occur. Accounting rules have been changed (in the US under the Current Expected Credit Loss (CECL) model and under IFRS 9 in the rest of the world) to anticipate losses from the day the loan is granted: this is what accountants mean by moving from an “incurred loss model” (which needs an event to occur before a loss is recorded) to an “expected loss model”.
The expected loss model in IFRS 9 is complex and it requires banks to look into the future and to estimate the range of possible economic scenarios that might occur. Banks will have to decide what they think is going to happen to their customers and when. Although this will be done on a portfolio rather than individual borrowing level, they have to consider different circumstances, wider economic events and extreme conditions. This may sound onerous but anticipating future losses in this way will promote more prudent (i.e. later) recording of profits on the loans.
It is helpful to understand that the estimate of losses at any point in time is just that, an estimate. It is also worth noting that unforeseen future events cannot, by definition, be factored into these calculations, so economic shocks can still cause significant and sudden additional losses. This is one of the reasons banks have to hold substantial buffers of capital to absorb such losses if they arise and this is tested regularly by prudential regulators.
The new rules will come into force for 2018 year-end accounts. Banks have been working hard for the last few years both to ensure that they comply with the new requirements and to design disclosures to aid the understanding of users of their financial statements, particularly shareholders, other investors and the financial markets.
The overall impact of IFRS 9 will be that banks will report their losses sooner, but these are not new losses. They have been reflected in the lending decisions and only the timing of their recognition is affected.
While this treatment is more prudent, there are some real challenges. Measurement is highly subjective because it relies on an estimate. This element of forecasting will potentially lead to volatile results. When recession is predicted losses will accelerate, even if current economic circumstances are benign. Comparison between banks will be difficult since their view of the future could be radically different. Analysts looking at bank financial statements may find this problematic.
Disclosures in financial statements will be of key importance. Providing enough information on year-on-year changes, assumptions and projections will be vital to allow users to compare one bank with another where different assessments of the future have been used in the expected loss calculations.
It is going to take time for the rules to bed down, and for people reading bank financial statements to understand them. ICAEW aims to help in this process wherever it can.
If you would like more detailed information and guidance through some of the terminology used please see our separate briefing paper for analysts and other market participants.