Measuring and Managing the Impact of New Impairment Models on Dynamics in Allowance, Earnings and Bank Capital

Amnon Levy and Jing Zhang

 

INTRODUCTION

Reserving for loan loss is one of the most important accounting aspects for banks. Its objective is to cover estimated losses on impaired financial instruments due to defaults and nonpayment. Reserve measurement affects both the balance sheet and income statement. It impacts on earnings, capital, dividends and bonuses, and attracts the attention of bank stakeholders ranging from the board of directors and regulators to equity investors. In response to the so-called “too little, too late” problem experienced with loan-loss reserve during the global financial crisis, accounting standard setters now require that banks provision against loan loss based on expected credit losses (ECLs). Arguably, calculating the ECL model under IFRS 9 and CECL presents a momentous accounting change for banks, with the new standards coming into effect sometime between 2018 and 2021, depending on the jurisdiction.

The new impairment models required to meet these standards replace existing “incurred-loss models” with more forward-looking approaches that incorporate future credit-loss forecasts. Regulation requires that banks recognise and update ECL at each reporting date to reflect cr

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