III Loan Loss Provisioning

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					III. Loan Loss Provisioning


» 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

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

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)
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
 » Impairment loss to be included in profit and loss
Incurred Loss Model of IAS 39
The Model (3)

objective evidence
of impairment        individually significant       not individually significant
(trigger events)
                      indication                no indication

test of actual            individually                    collectively
                     impairment                 no impairment

impairment                individually                     collectively

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
Incurred Loss Model of IAS 39

» Expected losses not recognised before trigger events occur
» Overstatement of interest revenue before trigger event
» 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

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

 Expected Loss Model
 (IASB ED/2009/12)

» June 2009: Request for Information
  Impairment of Financial Assets: Expected Cash Flow
  Approach (Expected Loss Model)
» 5th 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: 30th June 2010
» Final Standard: 2010
» Application: 2013 ?
               (around 3 years after final standard)

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
   • Reversal of impairment loss when expectations change
   • Re-estimation of expected cash flows each period

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

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

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
       - 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

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
   • 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           4949
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

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

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

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