As new accounting rules look set to enforce earlier recognition of credit losses,bank earnings and capital ratios could become less predictable. Standard & Poor’s Osman Sattar describes possible measures bank management may take as they prepare for this hit,and how regional differences could affect the magnitude of the impact.
The methods used by banks when calculating credit losses have come under close scrutiny from regulators after their weaknesses came to light during the financial crisis. The current “incurred loss” approach is being replaced with new rules mandating a more forward-looking, counter-cyclical impairment model which accounts for “expected” losses.
As such, the new models – in both IFRS and U.S. GAAP–will most likely see banks’ loss reserves increase on initial application and – holding all else equal –capital ratios decline. We could see shifts in bank management strategies with the re-working of loan product policies and price increases possible. However, the extent to which a bank will feel this varies across regions – with western European banks likely to suffer the most.
New rules: IFRS vs U.S GAAP
Despite having the same goal – to adopt an “expected loss” approach when estimating credit losses – the IFRS and expected U.S. GAAP rules will differ significantly. The new IFRS model is set out in IFRS 9 (which replaces the existing IAS 39)and has a “dual measurement” approach. This means that, on initial recognition of an underlying asset (such as a consumer loan or mortgage)banks must recognise a 12-month expected credit loss allowance. And, although this allowance must be updated to reflect the latest information in each reporting period, recognition of a lifetime expected credit loss is only required if and when the credit risk of the financial asset significantly increases.In contrast, the expected U.S. GAAP model – which is expected to be finalised this year – uses a “single measurement” approach that requires a lifetime expected credit loss allowance to be established as soon as the underlying asset is recognised, with updates to reflect new information in each reporting period.
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This lack of convergence is a major concern for the market, creating unnecessary confusion in financial reporting and undermining global peer analysis. What’s more, credit loss allowances and key metrics that are not directly comparable create significant disadvantages for investors. We therefore believe investors would be best served if banks using IFRS disclosed their estimated lifetime credit losses, as is expected to be required under U.S GAAP. While IFRS 9 does not require this, bank regulators should consider mandating this type of additional disclosure to provide investors with globally comparable information on credit losses.
Bankcapital ratios will suffer
The new credit loss models will likely result in higher credit loss allowances on initial adoption thus decreasing banks’ capital globally.Predictions of the impact of IFRS 9 – gathered from 54 global banks – revealed that more than half believe that credit loss provisions will increase by up to 50%,and 70% believe IFRS 9 will increase Common Equity Tier 1 (CET1) capital requirements.Similarly, regulatory impact studies in the U.S. show that credit loss allowances would increase by 30% to 50% across the U.S. banking system if the proposed U.S. GAAP model was applied, with the effect on specific banks dependant on individual factors, such as loan portfolios.
As loss reserves potentially balloon in the coming years – the new requirements will come into effect from 2018 at the earliest –our analysis shows that if the requirements were applied today, Western European banks will be hit hardest. We estimate that every 10% rise in the allowance would result in an average fall of 53bps in Western European banks’ core tier 1 ratios. In contrast, when faced with the same scenario, Eastern European, Middle Eastern and African (EEMEA) banks core tier 1 ratios fall by 17 bps. Banks in the U.S. and Canada fare better, with a drop of12bps and 10bps respectively.
But should credit-loss allowances rise by 50%, we estimate that U.S. banks’ core tier 1 ratios could take a hit of up to 61bps. While undoubtedly significant, this pales in comparison to the drop of 265 bps seen in Western European banks’ core tier 1 ratios when subject to the same credit-loss allowance increase.
These differences result from a combination of factors. For example, there is a greater level of disintermediation in the U.S. banking system, with European banks retaining a relatively larger proportion of loans on their balance sheets. Secondly, the speed at which assets are written off can vary dramatically. Legal processes such as foreclosure tend to be slower in southern Europe, meaning that these banks often carry high levels of provisioning against impaired assets for a longer time.
It is likely that banks will shift management strategies to mitigate the effects on capital. One possible change is a re-working of loan-product policies, favouring short-term loan products, or adding renewal options to contractual terms in order to shorten the duration of certain commercial loan products.Alternatively, increased pricing on some loan products (such as corporate loans or mortgages) to compensate for higher loan provisions is a possibility. In extreme cases, bank management teams may decide to significantly curtail the underwriting of new loan products simply to avoid both the accounting consequences of establishing reserves and taking an earnings hit in a specific reporting period, particularly where earnings are already under pressure.