«WP/14/170 Supervisory Roles in Loan Loss Provisioning in Countries Implementing IFRS Ellen Gaston and In Won Song WP/14/170 © 2014 International ...»
Supervisory Roles in Loan Loss Provisioning in
Countries Implementing IFRS
Ellen Gaston and In Won Song
© 2014 International Monetary Fund
IMF Working Paper
Monetary and Capital Markets Department
Supervisory Roles in Loan Loss Provisioning in Countries Implementing IFRS
Prepared by Ellen Gaston and In Won Song1
Authorized for distribution by Michaela Erbenova
This Working Paper should not be reported as representing the views of the IMF.
The views expressed in this Working Paper are those of the authors and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the authors and are published to elicit comments and to further debate.
Abstract Countries implementing International Financial Reporting Standards (IFRS) for loan loss provisioning by banks have been guided by two different approaches: International Accounting Standards (IAS) 39 and Basel standards. This paper discusses the different accounting and regulatory approaches in loan loss provisioning, and the challenges supervisors face when there are different perspectives and lack of guidance from IFRS. It suggests actions that supervisors can take to help banks meet regulatory and capital requirements and, at the same time, comply with accounting principles.
JEL Classification Numbers: G2, G21, G280, M41, M480 Keywords: Supervisory role, loan loss provisioning, IFRS implementation Author’s E-Mail Address: firstname.lastname@example.org; email@example.com We would like to express our appreciation to Michaela Erbenova for her support and guidance throughout the production of this paper. We would also like to thank Miguel A. Savastano, Pierpaolo Grippa, Alejandro Lopez, Fabiana Melo, Michael Moore, Katharine Seal, and Kenneth Sullivan (all MCM), and Linda Ditchkus (MCM expert), for their useful comments. Any remaining errors are the responsibility of the authors.
Contents Page I. Introduction
II. A World of Dual Provisioning Approaches: IFRS and the Basel Regime
A. IFRS – IAS 39
B. The Basel Regime
C. Where Do They Meet and Clash?
III. The New Accounting Credit Loss Recognition Framework–IFRS 9
IV. Implications for Supervisors
A. Balancing Accounting and Regulatory Approaches
B. Balancing Provisioning and Capital Requirements
C. Dealing With Common Provisioning Issues in Countries Implementing IFRS......18 V. Summary and Concluding Remarks
1. Summary of Common Provisioning Issues under IAS 39
1. Guiding Principles for the Replacement of IAS 39
2. Provisioning and Supervisory Practices
3. Capitalization versus Provisioning
1. Supervisory Powers in Loan Loss Provisioning in Selected Countries
2. Common Provisioning Issues in Countries Implementing IFRS
2.1.When a Country Transitions from Local GAAP to IFRS
2.2.Financial and Regulatory Reporting Implications
2.3.Interest Income on Impaired Loans – to Accrue or not to Accrue
2.4.Uncollectible Loan Write-off
2.5.Valuation and Sale of Collateral in Possession
Annex Box A1. Benefits of Timely Write-off of Uncollectible Loan
For countries implementing International Financial Reporting Standards (IFRS),
current loan loss provisioning by banks has been influenced by two sets of approaches:
International Accounting Standards (IAS) 392 and the Basel Regime.3,4 Since the first Basel Capital Accord in 1988, the two regimes have remained different and continue to exert almost equal weights in shaping banks’ loan loss provisioning practices. IAS 39 recognizes impairment losses based on an incurred loss based model, which only permits recognition of credit losses supported by “objective evidence.” This approach has been viewed as recognizing impairment losses “too little and too late.” As a result, provisioning under IAS 39, as practiced,5 often does not meet supervisory requirements from the perspective of credit risk review and capital adequacy assessment.6 Inherent in the “dual-approach” system are diverging perspectives between accountants and supervisors. The accounting and auditing professionals are charged with ensuring that impairment loss recognition and financial statement preparation are in accordance with IFRS. Bank supervisors, however, who are responsible for assessing credit risk and enforcing capital adequacy, not only make decisions on whether banks’ overall provisions are sufficient and timely, but may also have to bridge any gaps between accounting and supervisory requirements where necessary.
While IAS 39 is important in terms of credit loss recognition in countries implementing IFRS, supervisors fulfill their roles of assessing credit risk and enforcing capital adequacy of banks, in part, by ensuring sufficient and timely loan loss provisioning.7 IAS 39 is the current guiding accounting standard on impairment loss recognition. It will be replaced by IFRS 9, which was published by the IASB on July 24, 2014. Following the reorganization of International Accounting Standards Committee (IASC) into the International Accounting Standards Board (IASB) in 2001, new accounting standards issued by the IASB have been designated IFRS. At the same time, the IASB adopted all the existing IAS issued by the IASC.
Over 100 countries and jurisdictions worldwide have adopted IFRS. The levels of adoption vary, with the optimal form being the IFRS as issued by the IASB with no modifications. The IASB has a web site (Jurisdiction Profiles: http://www.ifrs.org/use-around-the-world/Pages/Jurisdiction-profiles.aspx), which provides detailed information on IFRS adoptions for 130 jurisdictions.
The Basel Regime in this paper refers to Basel Capital Accord I, II, III, and various guidelines issued by the Basel Committee on Banking Supervision (BCBS). Although Basel Capital Accord I, II and II are not provisioning standards, they include many important elements of loan loss provisioning. Basel III is largely similar to Basel II in terms of provisioning.
As IFRS is principle-based, banks use judgment in the application of IAS 39. There are various practices in identifying the existence of objective evidence, which may lead some to rely more on lagging indicators, such as past due status or default.
With the hindsight of the recent global financial crisis, some argue that both IFRS and the Basel Regime proved incapable of ensuring that banks were maintaining sufficient provisioning buffers.
Creating loan loss provisions reduces the net income of banks and thereby affects their capital positions.
Accounting is not the only element in the universe of loan loss provisioning and credit risk management. In addition to banks, accounting professionals, and external auditors, bank supervisors also have authority over the identification of impaired assets and measurement of provisioning levels. They exercise their judgment on the sufficiency of provisioning based on their overall assessment of banks’ credit risk management processes and methodologies.
Ultimately and crucially, through ensuring sufficient and timely loan loss provisioning, supervisors fulfill their roles of assessing banks’ credit risk and enforcing their capital adequacy.
Even though IFRS 9 has been published, IAS 39 will continue to be the guiding principle until IFRS 9 becomes effective in 2018, and some of the provisioning issues encountered by supervisors under IAS 39 may continue to be relevant under IFRS 9. At the request of the Financial Stability Board (FSB), G-20, and the BCBS, the IASB undertook a very high profile project to replace the incurred loss based accounting model with an expected loss based model for credit loss recognition.8 Since IAS 39 was criticized for allowing recognition of impairment losses “too little and too late,” the new model, IFRS 9, is expected to better align supervisory and accounting requirements by recognizing credit losses in a more timely manner and at an accelerated pace. However, whether the new model will be able to meet expectations is yet to be seen. With the slow progress of the development of the new model, IAS 39 has been “alive” for longer than expected, and will continue to be “alive” for the next few years until IFRS 9 becomes effective and replaces IAS 39 in 2018.
This signifies the continued importance of bank supervisors’ roles in loan loss provisioning under IAS 39, as discussed in this paper. In addition, some of the provisioning issues and challenges experienced currently will likely remain under IFRS 9, as also explored by the paper.
It is critical that bank supervisors possess the powers, willingness, and ability to act, as well as the technical expertise in both prudential supervision and accounting rules.
Bank supervisors should play an active role in helping banks to navigate the conceptual and practical differences between the two approaches and resolve specific issues in various situations.9,10 Sound and astute supervisory judgments are particularly needed given the This IAS 39 replacement project was also supposed to be a convergence project between IFRS and the U.S.
Generally Accepted Accounting Principles (GAAP). Unfortunately, however, accounting convergence, at least on credit loss recognition, is unlikely to happen soon. Although the IMF supports a single set of high quality, principle based international financial reporting standards, it is beyond the scope of this paper to discuss issues related to accounting convergence between IFRS and U.S. GAAP.
The “Sound Credit Risk Assessment and Valuation for Loans,” issued by the BCBS in 2006, provides high level principles guiding banks and supervisors in credit risk assessment and valuation practices. While the guiding principles are consistent with IFRS, the paper explicitly recognizes that it is not intended to bridge provisioning for credit risk assessment for accounting purposes to capital adequacy measures.
In addition, the revised Basel Core Principles for Effective Banking Supervision (BCP) (2012) reinforced essential criteria to establish what is expected of supervisors regarding provisions (for example, CP 18, ECs 4, 10, 11, and 12).
imprecise nature of loan loss provisions assessment. A review of evidence from recent IMF Financial Sector Assessment Programs (FSAPs) shows that bank supervisors have adopted a variety of supervisory approaches to ensure the adequacy of provisions within their jurisdictions (See Annex 1).
Recent developments in banking systems around the world illustrate the continued importance of proper provisioning. Two such examples are the Asset Quality Review (AQR) exercise in the EU and the European Banking Authority (EBA)’s initiative of unifying the definitions of non-performing loan and loans subject to forbearance measures.11 Credit quality inadequacies and their resulting losses have always been one of the primary causes of bank failures. Six years after the global financial crisis, despite ongoing regulatory reforms and rounds of organized stress testing, deleveraging, and balance sheet repair exercises, loan loss provisioning and asset quality remain key issues for banks. Provisioning merits particular attention given its vital role in ensuring the safety and soundness of the banking system. Another important event is that the BCBS has started working on issuing new supervisory guidance on provisioning for banks with an international footprint.12 This paper discusses the different accounting and regulatory approaches in loan loss provisioning, and the challenges supervisors face given the diverging perspectives or lack of guidance from IFRS. This ultimately translates into what supervisors should do to help banks meet regulatory and capital requirements and at the same time comply with the accounting principles. The paper aims to serve as a useful reference not only for countries facing these issues, but also for IMF mission work, i.e., FSAPs, TAs (Technical Assistance), and country surveillance.
The paper has five sections. Section II describes and compares the two current different approaches to loan loss provisioning. Section III discusses provisioning rules under the new accounting framework on credit loss recognition. Section IV examines the implications for supervisors: (i) in balancing accounting and regulatory approaches; (ii) in balancing provisioning and capital requirements; and (iii) in dealing with common provisioning issues in countries implementing IFRS. Section V concludes.
See EBA’s Final Draft Implementing Technical Standards (EBA/ITS/2013/03, February 20, 2014).
This was decided in anticipation of the new IFRS framework on credit loss recognition, as well as a probable lack of convergence between the IFRS and U.S. GAAP on this issue.
II. A WORLD OF DUAL PROVISIONING APPROACHES: IFRS AND THE BASEL REGIME
IAS 39 prescribes an “incurred loss” approach. This approach was designed to limit management’s ability to create hidden reserves that could lead to earnings management.