Banks are pressing regulators to ease capital rules to reflect the risk-reducing effect of higher loan loss reserves under new accounting standards.
According to an impact study by the European Banking Authority, IFRS 9 will force banks to increase loan loss provisions by as much as 30% and could cut Common Equity Tier 1 (CET1) ratios by up to 75 basis points. The equivalent US accounting standard – the Current Expected Credit Loss (Cecl) rule – could pack an even bigger punch.
As a result, lenders will need to raise additional capital despite setting aside bigger reserves to cover loan losses.
Banks say this amounts to double counting, and are calling for excess loan reserves to be added back to their CET1 capital buffers – or at the very least offset them against credit risk weighted assets (RWAs), which would indirectly improve capital ratios.
“We are concerned the accounting provisions will lead to double counting – that is, not account for the fact that the same losses are already capitalised under the regulatory capital framework,” says Andrea Schnoz, director of regulatory policy and finance at Barclays in Singapore.
The new accounting standards – IFRS 9 and Cecl – require banks to set aside reserves to cover expected credit losses (ECL) over the life of a loan. ECL is calculated with reference to a range of factors, including forecasts of credit conditions and economic variables.
We are concerned the accounting provisions will lead to double countingAndrea Schnoz, Barclays
Under the existing incurred loss accounting standard, banks only need to provision for losses when a loan becomes impaired.
ECL will require banks to maintain bigger loss reserves, which effectively translates into a capital hit. If a bank has a 10% capital ratio and loan loss reserves of 0.5% under the incurred loss model, and its loan loss provisions rise to 1% under ECL, the immediate effect will be to lower its capital ratio to 9.5% as retained earnings – which would ordinarily flow into CET1 capital – are diverted to bolster loan reserves.
But the risk-reducing effect of beefier loss reserves may not be reflected in bank capital requirements, due to differences in the way loan losses are estimated for accounting and regulatory purposes, and the way loan reserves are treated in the capital framework.
Basel III’s internal ratings-based approach (IRB) for calculating credit risk capital requires banks to estimate so-called regulatory expected losses (EL) based on the probability of default and loss given default over a 12-month period.
The Basel framework also recognises two types of reserves: specific provisions (SP) for identified loan losses – such as incurred losses under current accounting standards – and general provisions (GP) set aside to cover unexpected losses. Typically, only the latter is recognised as capital.
“The Basel accords were based on the idea that the loan loss allowance was to cover expected losses, and that capital was for unexpected losses,” says a source at a US prudential regulatory agency.
Loan reserves are typically regarded as SP and most experts believe ECL provisions will receive the same treatment.
The IRB, which is used by most big banks, does not distinguish between SP and GP, however. Instead, total eligible provisions – the sum of SP and GP – are compared to EL and any shortfall is deducted from CET1 capital. Any excess reserves can be included in Tier 2 capital up to a limit of 0.6% of credit RWAs.
The reduction in RWAs produced by SP will not be enough to offset the increased consumption of capital produced by higher loan loss reservesLourenco Miranda, Societe Generale
But the distinction is important for banks using the standardised approach for calculating credit risk capital. Under the standardised approach, SP is deducted from exposures before they are risk-weighted, while GP is included in Tier 2 capital up to a limit of 1.25% of credit RWAs.
ECL accounting will result in these banks holding a lot more SP reserves, which do not count as capital.
That means the transition to ECL accounting could be particularly painful for banks using the standardised approach, as the reduction in RWAs from higher SP is unlikely to fully offset the depletion in capital to bolster loan reserves.
“For standardised banks, the reduction in RWAs produced by SP will not be enough to offset the increased consumption of capital produced by higher loan loss reserves,” says Lourenco Miranda, a stress testing and capital planning expert at Societe Generale in New York.
The effect is less clear cut for IRB banks due to the more complex relationship between the ECL and EL formulas.
In a discussion paper on the regulatory treatment of accounting provisions issued in October 2016, the Basel Committee on Banking Supervision floated the idea of eliminating the distinction between SP and GP and introducing a schedule of expected loss rates for the standardised approach – bringing it more in line with the IRB.
The US agencies don’t see the point in models. That’s why they are pushing for a standardised floor to be applied to banks that operate under the model-based approachRegulatory expert at a European bank
“The long-term project is to harmonise the distinctions, and make it consistent for both standardised and advanced approach banks,” says Jonathan Prejean, managing director at Deloitte Advisory in New York.
However, the Basel Committee also made it clear in its discussion paper that it is not currently considering any changes to the regulatory treatment of accounting provisions in the IRB framework. That has raised the ire of some bankers, who argue that while banks using the standardised approach will be worst hit, the discrepancies between ECL and EL will affect IRB banks too.
This is because ECL, which measures losses over the life of a loan, could at times significantly exceed 12-month EL under IRB – forcing banks to set aside extra reserves against losses that are already factored into capital calculations.
“In the discussion paper, they waved the distinction [between IRB and SA] away because their concern is more about the standardised approach, but in our view, just as there’s an overlap under the standardised approach, there’s also an overlap under the IRB,” says a regulatory capital expert at a large European bank.
The discussion paper has also reignited fears that the Basel Committee wants banks to move away from the IRB and adopt the revised standardised approach. US regulators are said to be sceptical of the IRB, while their European counterparts want to preserve it.
“That’s the elephant in the room,” says the regulatory capital expert at the European bank. “The US agencies don’t see the point in models. That’s why they are pushing for a standardised floor to be applied to banks that operate under the model-based approach. The question is to what extent the Basel process as a global standard is at stake, and whether it will be a case of national supervisors implementing their own approaches.”
The industry outlined its preferred solution in a series of comment letters filed with the Basel Committee, which called for any excess loan losses set aside to cover ECL over the life of a loan to be added back to CET1 capital. “To ensure consistency with the IRB approach in offsetting the ECL impact, the difference between lifetime expected loss and 12 months ECL should be incorporated within CET1,” the European Banking Federation wrote in its comment letter.
Barclays, meanwhile, called for “a reduction in the capital requirements for credit losses by an amount equal to the excess of eligible provisions above the regulatory expected loss”.
We encourage regulators to look at an RWA multiplier or some other adjustment to RWAsAndrea Schnoz, Barclays
However, that is unlikely to fly with the Basel Committee, which is said to hold firm to the view that such reserves are set aside to absorb expected loan losses, while CET1 is used to absorb all forms of unexpected losses incurred by a bank, including those linked to operational and market risks.
“This capital layer is not fungible to be used for other losses such as a large fine,” says the regulatory capital expert at the European bank. “If a bank has to pay a large conduct fine, it could use accounting provisions to absorb that loss. Because of that, the regulators don’t want banks to reinsert these excess provisions into CET1.”
As a compromise, several banks – including Barclays and HSBC – proposed using excess loan loss provisions to reduce credit RWAs. This could be done by multiplying the excess provisions above 12-month EL by 12.5 – equivalent to an 8% capital charge – and deducting this amount from RWAs of an entire loan portfolio or on a loan-by-loan basis.
“We encourage regulators to look at an RWA multiplier or some other adjustment to RWAs,” says Schnoz at Barclays. “It’s a consistent and logical methodology as opposed to adding another layer to capital.”
Meanwhile, the European Commission has already said it will allow banks to add back a gradually diminishing portion of their ECL provisions for performing loans to their CET1 capital over a period of five years as they transition to IFRS 9.
The Basel Committee issued a consultation paper in October 2016 that laid out various options for the transition to IFRS 9 and Cecl, ranging from full neutralisation of the capital impacts on day one to amortising the cost on either a straight-line or dynamic basis.
A final recommendation on interim approaches and transitional arrangements – which could provide some hints as to the Basel Committee’s thinking on the regulatory treatment of ECL provisions more broadly – is understood to be imminent, and could be issued in “a matter of days”, according to a source familiar with the matter.
The more challenging side of sensitivity to economic variables means your allowances quarter to quarter can change, even if the underlying characteristics of your borrowers have not changedAnna Krayn, Moody’s Analytics
Bankers say they will continue to press their case even if the Basel Committee rejects the proposals outlined in their comment letters. “The Committee isn’t going to allow adding excess provisions back into CET1, hence it’s up to the industry to come up with an alternative approach that’s acceptable to regulators,” says the regulatory capital expert at the European bank.
The Basel Committee declined to comment.
Perils of procyclicality
Banks are already warning that – in the absence of regulatory relief – the new accounting standards could have a dangerously procyclical effect on loss provisioning and capital planning, and result in more volatile capital ratios.
This, they argue, is because EL for IRB is calculated using a ‘through-the-cycle’ approach that measures the average probability of default over 12 months, while ECL relies on a ‘point-in-time’ approach that estimates probability of default based on the prevailing credit conditions at quarter-end. As a result, ECL is likely to be far more volatile than EL.
“The more challenging side of sensitivity to economic variables means your allowances quarter to quarter can change, even if the underlying characteristics of your borrowers have not changed,” says Anna Krayn, senior director at Moody’s Analytics in New York. “So you have more potential movement in allowance balances than you had under the incurred loss model.”
The concern is that EL will exceed ECL when economic conditions start to deteriorate, forcing banks to take a capital hit when they can least afford to do so. On the other hand, ECL reserves may exceed EL in boom times; however, banks will not be able to add these excess reserves to CET1.
The effect is likely to be more pronounced under IFRS 9, which places loans in three buckets: performing; impaired; and defaulted. As loans go from performing to impaired, banks will need to move from provisioning for 12-month expected losses to lifetime expected losses.
“As soon as the credit quality of your borrower deteriorates, you will need to switch to lifetime expected losses,” says the regulatory capital expert at the European bank. “When you apply a stressed scenario, a lot of performing loans will move to impaired, hence the provision will become greater under the stressed scenario. If you now have even bigger provisions, then calls for reinserting them into CET1 get even louder from the industry.”
That argument doesn’t seem to carry much weight with regulators, though. “My reaction to the procyclical argument is that the solution is not to pretend some losses don’t exist for the purpose of calculating regulatory capital. Instead, the solution is for banks to build buffers over capital requirements that will allow them to absorb losses from a reasonably plausible stress situation, such as by running their own stress tests that focus on vulnerabilities in their balance sheet,” says the source at the US prudential regulatory agency.