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, 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.
Prior to and during the financial crisis, loan loss provisions were based on an “incurred loss model” which only permitted banks to recognise losses once loss events became observable. For example if borrowers lost their jobs and/or stopped loan repayments. This model was heavily criticised in the wake of the financial crisis because it was perceived to provide for losses “too little, too late” and was “pro-cyclical”, i.e. it allowed excess profits to build up in the good times, causing much higher losses to have to be recorded in the bad times. The pro-cyclicality allowed a credit bubble to develop based on underestimated credit losses which led to an over-optimistic assessment of bank’s reported profits.
In 2009 the G20 (an international forum of the governments and central bank governors from 20 major economies) called for accounting standard-setters to adopt a more forward-looking approach. The new rules are contained in IFRS 9 Financial Instruments. In the US the Current Expected Credit Loss (CECL) model requires lifetime expected losses to be booked on day one. In effect banks will be forced to start estimating credit losses from the date when the loan was taken out and over the course of its lifetime based on the degree of credit deterioration.
Banks have, for many years, been required to assess their expected losses for banking regulatory purposes. Currently these rules require them to calculate their expected losses for the next 12 months from the reporting date. In many cases the banking regulatory requirements are more prudent than the IFRS 9 ones and it is very unlikely that the expected loss estimates would be the same; this is not surprising as they have different objectives.
When applying IFRS 9 principles, there are three different stages of measuring impairment. Most exposures will initially be in Stage 1. The bank recognises only the credit loss associated with the probability of default within the next 12 months as a provision against the asset. However, as soon as the exposure has suffered a significant increase in credit risk (‘Stage 2’), the bank recognises an allowance equal to expected credit losses over the lifetime of the loan. IFRS 9 does not specify what constitutes a significant increase in credit risk. Preparers have to define it for themselves. Transfers between Stages 1 and 2 are based on relative movement in credit risk since origination rather than based on absolute level of risk. The expected loss over the lifetime of a loan is likely to be significantly higher than the expected loss for the next 12 months.
Stage 3 includes financial assets that have objective evidence of impairment at the reporting date. For these assets lifetime expected loss is calculated for accounting purposes on the same basis as exposures in Stage 2; so the movement between the Stages 2 and 3 in itself, will not change the provision made.
It is a challenge for a bank to track the changes in credit risk for each loan from inception, but also to predict the range of future events that might have an impact on the losses. Differing judgements will make comparison between banks very difficult: there may be little consistency between them regarding the assessment of the credit risk since the relative movement depends on their individual starting points, when the original loan was granted. Furthermore, the interpretation of ‘significant increase’ in credit risk is expected to vary significantly.
Banks are working hard to apply the rules and to give helpful information to users of their financial statements, so that the impacts of the changes are as clear as possible. There are challenges and difficulties, however, and it is helpful to keep these in view as the new requirements bed down over time.
1. Inherent difficulties of predicting the future
Predicting the future is hard and assumptions, including the range of possible outcomes of economic events, might vary considerably between banks. Financial reporting has other areas (e.g. goodwill and deferred tax) where the value of assets is being estimated. However, estimating loan losses will be on a different scale. Small movements in predictions, for example a gentle growth forecast turning into a prediction of an impending recession, will produce massive differences in the amount of expected credit loss to be provided for.