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III. Loan Loss Provisioning
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Agenda
Loan Loss Provisioning a key to a true and fair view in
bank accounting and prudent banking supervision
Incurred Loss Model of IAS 39
The Model
Shortcomings
Expected Loss Model (IASB ED/2009/12)
The Model
Application challenges
Accounting Impairment vs. Expected Loss in Basel II
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Loan Loss Provisioning
Key for a faithful presentation in the Accounts of Banks
Key for Bank Accounts as a sound basis for banking
supervision purposes
Inherent trade off as Loan Loss Provisioning should
lead to a reliable measurement of financial assets (loans)
not over estimate financial assets (loans)
not result in hidden reserves
lead to a timely recognition of risk provisioning
In addition Loan Loss Provisioning should have a counter-
cyclical effect from a stability point of view
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Incurred Loss Model of IAS 39
The Model (1)
Impairment Identification for Financial Instruments at cost
At each balance sheet date, financial assets or group of
financial assets to be tested for objective evidence of
impairment (IAS 39.58 and .59)
Impairment measurement
No Loan Loss Provisions at initial recognition (day one)
Financial Instruments that are individually significant
- testing for objective indication of impairment
- testing for actual impairment individually
Otherwise testing for actual impairment collectively (portfolio basis)
To be recognised it is necessary that there is objective evidence
of impairment; that impairment-events have arisen after
issuance (trigger events IAS 39.59)
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Incurred Loss Model of IAS 39
The Model (2)
Impairment measurement calculation of specific
impairment (IAS 39.63, AG84)
Impairment loss as the difference between carrying amount
and discounted value of the estimated future cash flow using
the original effective interest rate
Effective interest rate on variable-rate financial instruments is
the current contractual effective interest rate
Short-term receivables are not discounted if the resulting
effect is immaterial
Valuation at current market price permissible as a simplification
measure
Impairment loss to be included in profit and loss
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Incurred Loss Model of IAS 39
The Model (3)
objective evidence
of impairment
(trigger events)
individually significant not individually significant
test of actual
impairment
impairment
individually collectively
individually collectively
indication
no indication
impairment
no impairment
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Incurred Loss Model of IAS 39
The Model (4)
Impairment measurement calculation of portfolio value
Financial assets are grouped due to similar credit risk
characteristics (IAS 39.AG87)
IAS 39.59(f) observable data indicate that there is a measurable
decrease in the estimated future cash flows
Future cash flow to be calculated from historical default rates
adjusted for current market conditions (IAS 39.AG89)
According to IAS 39, an allowance for collective (portfolio)
impairment on a performing portfolio has to be established for
incurred but not (yet) reported losses
Formula-based approaches or statistical methods may be used for
calculation (IAS 39.AG92)
Similarities to Basel II EL calculation possible
Formula need amongst others Loss Identification Period (LIP-Factor)
EL = (Carrying Amount Collateral) x PD x LIP
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Incurred Loss Model of IAS 39
Shortcomings
Expected losses not recognised before trigger events occur
Overstatement of interest revenue before trigger event
(front-loading)
Does not reflect the underlying economics of the transaction
Triggers inconsistently applied in practices
Loss recognition too late
During the financial crisis there has been clear evidence that
IAS 39 incurred loss model resulted in delayed loss recognition
and has a cyclical effect
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Forward Looking Provisioning
G 20 request (April 2009 London Summit)
We agree [] to call on the accounting standard setters to
work urgently with supervisors and regulators to improve
standards on valuation and provisioning and achieve a single
set of high-quality global accounting standards
We have agreed that accounting standard setters should []
strengthen accounting of loan-loss provisions by incorporating
a broader range of credit information
Strengthened regulation and supervision must [] dampen
rather than amplify the financial and economic cycle
In future, regulation must [] require buffers of resources to
be built up in good times
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Expected Loss Model
(IASB ED/2009/12)
June 2009: Request for Information
Impairment of Financial Assets: Expected Cash Flow
Approach (Expected Loss Model)
5
th
November 2009 ED/2009/12
(phase 2 of IAS 39-Replacemet Project)
Financial Instruments: Amortised Cost and Impairment
Establishment of Expert Advisory Panel
Comment deadline: 30
th
June 2010
Final Standard: 2010
Application: 2013 ?
(around 3 years after final standard)
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Expected Loss Model (IASB ED/2009/12)
The Model (1)
Main outcomes of the ECF approach
Single impairment model to be used
Earlier recognition of impairment losses
Eliminates front loading of interest revenue
Better reflects underlying economics
(e.g. pricing of instruments when lending decision is made)
Main features of the ECF approach
Interest revenue is recognised on the basis of expected cash
flows (including initial expected credit losses)
Impairment results from an adverse change in credit loss
expectations
Reversal of impairment loss when expectations change
favourably
Re-estimation of expected cash flows each period
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Expected Loss Model (IASB ED/2009/12)
The Model (2)
Objective:
To improve the accounting for provisions for losses on loans
taking into consideration expected losses, resulting in more
timely recognition of losses
To reflect the economic reality of lending by recognising
interest revenue as a credit cost adjusted return, which
eliminates the frontloading of interest revenue
Scope:
The requirements of the ED shall be applied to all items
within the scope of IAS 39 that are measured at amortised
cost
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Expected Loss Model (IASB ED/2009/12)
The Model (3)
The Expected Loss Model requires
to determine the expected credit loss on the financial asset
when that asset is first obtained
to recognise contractual interest revenue, less the initial
expected credit losses, over the life of the instrument
to build up a provision over the life of the instrument for the
expected credit loss
to reassess the expected credit loss each period
to recognise immediately the effects of any changes in credit
loss expectations
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Expected Loss Model (IASB ED/2009/12)
The Model (4)
Measurement Principles
Amortised cost shall be calculated using the effective interest
method. Hence, amortised cost is the present value calculated
using
- the expected cash flows over the remaining life of the
financial instrument
- the effective interest rate as the discount rate
The estimate for the cash flow inputs are expected values.
Hence, estimates of the amounts and timing of cash flows are
the probability-weighted possible outcomes
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Expected Loss Model (IASB ED/2009/12)
The Model (5)
Amortised cost is the amount at which a financial asset is
measured at initial recognition adjusted over time as
follows
minus principal repayments
plus or minus the cumulative amortisation using the effective
interest method of any difference between the initial amount
and the maturity amount
plus or minus any addition or reduction resulting from the
effect of revising estimates of expected cash flows (e.g.
regarding prepayments or uncollectibility) at each
measurement date
The estimate of expected cash flows has to consider
All contractual terms of the financial instrument
(e.g. prepayment, call or similar options)
Credit losses over the entire life of the asset
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Expected Loss Model (IASB ED/2009/12)
The Model (6)
Presentation
The statement of comprehensive income shall inter alia include
the following:
Gross interest revenue ( = contractual interest revenue)
- Initial expected credit losses (portion allocated to the period)
_________________________________________________
= Net interest income revenue ( = economic interest revenue)
Gains and losses resulting from changes in credit loss expectation
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Expected Loss Model (IASB ED/2009/12)
Application Challenges
Establishment of a Expert Advisory Group
Advise the Board on how operational challenges of the ECF
approach might be solved
Assist in field testing
Extensive outreach activities
Many practical issues in applying the new impairment rules
have to be solved
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Accounting Impairment vs. Expected
Loss in Basel II
Time horizon
IASB / Accounting: Lifetime of the financial instrument
Basel / Supervision: one-year PDs
Calculation base
IAS 39: focus on categories at amortised cost;
different methods
Basel II: investment book; EL = EAD x LGD x PD
Default definition
IAS 39.59: trigger events
Basel II: debtor is unlikely to pay / 90 day past due
Interest rate
Basel: no reflection
IAS 39: relevance of effective interest rate
Common use of data base seems to be possible