1. BSCEE Annual Meeting Dubrovnik, Croatia Loan Loss Provisioning - Today and in the Future - Jason George Financial Stability Institute 27 May 2004

2. Agenda Introduction: Why is Provisioning Important The Foundation for Proper Provisioning The Concept of Impairment Future Provisioning Issues –Fair value accounting –Dynamic / Statistical Provisioning

3. Rationale The most common cause of bank failures, by far, is poor credit quality and credit risk management Unless deterioration is identified and losses recognised by the establishment of allowances or charge-offs in a timely manner, a bank may persist in highly risky lending strategies or practices and thus accumulate significant loan losses Capital requirements provide some cushion against loan losses (UL), but if the underlying credit risk policies and practices are weak, the resulting capital cushion may well be overstated

4. Mandate Further harmonisation and the strengthening the transparency of loan measurement, the establishment of loan loss allowances and credit risk exposures –Basel Committee –G7 Finance Ministers –G10 central bank Governors –International Financial Institutions (IMF and WB)

5. Core Principles for Effective Banking Supervision Principle 8: “banks establish and adhere to adequate policies, practices and procedures for evaluating the quality of assets and the adequacy of loan loss provisions and loan loss reserves” Principle 21: “each bank maintains adequate records drawn up in accordance with consistent accounting policies and practices that enable supervisors to obtain a true and fair value of the financial condition of the bank and the profitability of its business”

6. Loan Accounting Primary Concerns Adequacy of the institution’s process for determining allowances The adequacy of the allowance itself The timely recognition of impairment losses through either allowances (specific or collectively assessed) or charge-offs Timely and accurate credit risk disclosures

7. Scope of Consideration Within the scope of this discussion: –Loans held at amortised cost in the banking book Outside of the scope of this discussion: –Loans measure at fair value (loans held for trading or available for sale or loans qualifying for fair value hedging relationships) –Fiscal (ie tax) considerations…these may provide disincentives to timely and adequate loan loss provisioning

8. Agenda Introduction: Why is Provisioning Important The Foundation for Proper Provisioning The Concept of Impairment Future Provisioning Issues –Fair value accounting –Dynamic / Statistical Provisioning

9. The Foundation for Proper Provisioning Banks must have a system in place to classify all loans on the basis of risk…such system can be established by –The institution itself or –The supervisor Recognition and measurement of loan impairment cannot be based solely on specific rules or formulae but involve a mix of rules and judgement by management –Actual loss experience or observable data may be limited or not directly relevant to current circumstances –Management may be required to use expert credit judgement to estimate impairment losses

10. Expert Credit Judgement Scope for discretion when using expert credit judgement should be prudently limited Documentation should be in place to enable an understanding of the procedures performed and judgements made by management A key area in which expert credit judgement is used is in adjusting the historical loss rates on groups of loans for current circumstances

11. The Philosophy of Allowances Collective Assessment (sometimes referred to as general provisions): Incurred losses that cannot yet be ascribed to individual loans. This covers loans that were not individually evaluated for impairment and those loans that were evaluated but not identified as impaired UK Statement of Recommended Accounting Practices (SORP): “…portfolios of advances often contain advances which are in fact impaired at the balance sheet date, but which will not be specifically identified until some time in the future…To cover the impaired advances which will only be identified as such in the future, a general provision should be made”

12. The Philosophy of Allowances Specific provisions: Focus is on the procedure to arrive at a net book value of individual loans to establish specific allowances to cover ascertained and estimated losses in those loans on an item-by-item basis –Identified but not yet finally determined losses are recognised through specific allowances instead of charged off –As a second step, additional collectively assessed allowances may be established UK Statement of Recommended Accounting Practices (SORP): “A loan is impaired when, based upon current information and events, the bank considers that the creditworthiness of the borrower has undergone a deterioration such that it no longer expects to recover the advance in full”

13. Agenda Introduction: Why is Provisioning Important The Foundation for Proper Provisioning The Concept of Impairment Future Provisioning Issues –Fair value accounting –Dynamic / Statistical Provisioning

14. What is Impairment? An impairment loss should be recognised if objective evidence and management’s expert credit judgement indicate that the bank will not be able to collect all amounts due according to the contractual terms of the loan agreement The impairment should be recognised by reducing the carrying amount of the loan(s) through an allowance (specific or collectively assessed) or a charge-off To ensure recognition of impairment losses on a timely basis, loans should be reviewed for impairment on a regular basis

15. When Does Impairment Occur? The evaluation of a borrower or group of borrowers should be based upon the creditworthiness of the borrower or of the group to which the borrower belongs It may not be possible to identify a single event that causes impairment Attributes relevant to the assessment of the bank’s ability to collect the loan may include: –Payment record– Overall financial condition –Debt service capacity– Financial performance –Net worth– Guarantors –Collateral protection

16. A Word on Collateral… In general, bankers and supervisors rely too heavily on collateral as a source of repayment Management must establish a programme to periodically monitor and analyse collateral and its value Management should review each appraisal’s assumptions and conclusions to ensure timeliness and reasonableness –Management’s review should be documented in writing –Weaknesses in the legal system and other obstacles that make it difficult to ensure rights should be taken into account

17. Objective Evidence of Impairment??? Disappearance of an active market because an entity’s financial instruments are no longer publicly traded? Downgrade of an entity’s credit grade? Decline in the fair value of a loan below its amortised cost? Significant financial difficulties of the borrower (eg as indicated by liquidity or cash flow projections)? Breach of contract? Probability of bankruptcy or financial reorganisation of the borrower? Disappearance of an active market for the loan (s) because of financial difficulties of the borrower? Granting of loan concessions to the borrower for reasons relating to his financial condition?

18. Measurement of Impairment Impaired loans are measured at their estimated recoverable amount Estimated recoverable amount is the present value of estimated future cash flows discounted at the loan’s original effective interest rate Groups of loans can be collectively assessed and a collective assessment provision (see slide 12) can be established.

19. Collective Assessment for Impairment Collectively assessed loans should be grouped into categories with similar credit risk characteristics In determining collectively assessed allowances, past experience and current economic conditions as well as changes in lending policies, nature and volume of the loan portfolio, concentrations of credit and the nature and severity of recently identified impaired loans should be taken into account

20. Returning a Loan to Unimpaired Status All past due principal and interest has been paid and remaining payments according to the loan agreement are expected. The borrower has resumed paying the full amount of the scheduled contractual principal and interest for a reasonable period and all remaining contractual payments are deemed collectible in a timely manner The loan becomes well secured and in the process of collection (through legal or other action that will result in repayment of the loan or restoration to current status in the near future)

21. Agenda Introduction: Why is Provisioning Important The Foundation for Proper Provisioning The Concept of Impairment Future Provisioning Issues –Fair value accounting –Dynamic / Statistical Provisioning

22. Fair Value Accounting IASB Discussion Paper in 1997 IASB Draft standard issued in 2001 based on full fair value accounting for financial instruments Basel Committee response: –Some conceptual appeal –Appropriate for trading activities –Considerable difficulties exist in reliably estimating the fair value of bank loan portfolios –Conclusion…the time is not right to prescribe full fair value accounting in the primary financial statements for all financial instruments of banks

23. The Spectrum of Provisioning Incurred Loss Models Expected Loss Models (with forward looking elements) Dynamic or Statistical Provisioning Where are we today?What possibilities lie ahead?

24. Dynamic Provisioning: Issues and Application Background The differences in in provisioning types (specific and collective assessment, see slides 12 and 13) is only one of implementation…in both cases provisions are made only in respect of impairment believed to exist at the balance sheet date Can these provisioning approaches include forward looking elements?

25. Dynamic Provisioning: Issues and Application Expected and Unexpected Losses Banks expect that a proportion of their loan portfolios will be lost each year through default (expected losses) The expected losses, may, ex ante, be different from actual losses (unexpected losses) When calculating unexpected losses, banks think in terms of a confidence interval around the expected loss figure

26. Dynamic Provisioning: Issues and Application How do banks price loans? Expected Loss Premium: compensation to cover expected losses. The original expected loss premium on the loan portfolio, in theory, should cover originally expected losses. Unexpected Loss Premium: Actual default rates rarely equal expected default rates. The UL Premium builds capital. Market Position Premium: can be positive or negative and reflects the market position of the bank.

27. What is Dynamic Provisioning? Provisions are set against loans outstanding in each accounting time period in line with an estimate of long-run expected losses Lower volatility in earnings because provisions are based upon expected, rather than actual losses (a buffer is built during times when actual losses are less than expected losses and vice versa) Bank income is measured net of expected loss provisions, not net of actual losses Actual losses are set against expected loss provisions, including those accumulated from previous years

28. What is Dynamic Provisioning? If a bank experiences actual losses greater than the amount of accumulated expected loss provisions, the excess must be charged to the income statement; thus… Capital is used to cover unexpected losses (consistent with Basel II) Dynamic provisioning recognises that in practice, year-to- year patterns of expected and actual losses are likely to differ

29. Dynamic Provisioning Consideration Points Reduced procyclicaility in the income statement, leading to improved financial stability (?) Banks must be able to accurately estimate long-run expected losses (necessary for pricing) Requires the stock of expected loss provisions (dynamic provisions) to be built up ahead of any downturn Income smoothing Financial statements – reporting date Matching of income and expenses (?) Tax deductibility in most countries would not be possible (e.g. Spain)

30. Financial Stability Institute Jason George jason.george@bis.org (41 61) 280 8054