A smoothing approach to banking loan loss provisions could reduce earnings volatility
Banking sector interest groups are revisiting elements in the current financial services sector reporting framework which are heightening and exacerbating financial instability, say Tom Winterboer, PricewaterhouseCoopers (PwC) Banking and Capital Markets leader in South Africa.
“Several mechanisms in the financial services sector, including the interpretation of the present accounting treatment of loan loss provisions, are reinforcing pro-cyclicality. This means an amplification of the good in good times, and the bad in bad times” says Charles Morel, PricewaterhouseCoopers Director – Capital Markets Group in the UK.
South African banks currently apply the incurred loss approach in setting loan loss provisions as contained in the requirements of International Accounting Standard 39. Morel explains, that the ‘incurred loss’ approach is presently being inconsistently applied across different territories in the world. He mentions that “the inconsistent implementation of the incurred loss model can cause loan losses to be recognised too late in the credit cycle and this can intensify earnings volatility. ”
The Financial Stability Forum (FSF - an international body comprising members such as central banks, supervisory and regulatory authorities, the International Monetary Fund, The International Accounting Standards Board (IASB), and the G20 countries, together with non-members such as auditing firms and financial industry experts) proposes that the United States Financial Accounting Standards Board (FASB) and IASB consider alternative approaches to the current incurred loss model for recognising and measuring credit loan losses. These recommendations reflect the view that earlier recognition of loan losses could have dampened cyclical moves in the current crisis.
The FSF is analysing several options for banks in order to reduce procyclicality in their loan loss provisioning calculations. Costa Natsas, an Associate Director in the PricewaterhouseCoopers, Banking and Capital Markets Group in South Africa explains that, “The analysed approaches would include the fair value approach, the expected loss approach and a dynamic provisioning approach.”
The expected loss approach would be based on estimated future credit losses while the fair value solution would value the loans at the current price (based on observable data) and will encapsulate the future expected cash flows from the loan.
With a dynamic provisioning approach, banks would make provisions based on losses expected when loans are originated. This would allow for a build up of provisions during benign economic times which would then provide a buffer for periods when actual losses are high. “The criticism of the dynamic provisioning approach is that there is a risk that it is not a true reflection of the earnings of a particular year - it may contain an element of smoothing as reserve provisions are built up and then drawn down when required” says Morel.
“Under the current IFRS and US GAAP frameworks, the FSF indicates that there is room for Banks to use management judgment to ensure that loan loss provisions reflect current economic conditions, but banks could improve in this area. The FSF has requested accounting standard setters to emphasise to regulators, financial institutions and auditors that this approach does permit considerable use of managements’ expert credit judgement, and that they should not shy away from using this discretion. More effective use of discretion and judgement allowed by this approach would also contribute towards lessening pro-cyclicality.”
Natsas says that the matter of more effective loan loss provisioning is a priority for the FSF. “It has urged standard setters – particularly the US FASB - to expedite its recommendations. As South Africa adopts International Financial Reporting Standards, we would then follow what the IASB prescribes.” These provisioning approaches under consideration, revert to accounting practices which have been increasingly phased out of accounting frameworks over the last decade – being smoothing and provisioning practices which were criticised for detracting from the accuracy of the results being reported for a particular year.
Natsas notes that the accounting details of the approaches under consideration still need to be fleshed out. The debates inevitably relate to what should be going through the income statement and what goes through reserves. Clearer guidance is also required on how to implement the new approaches under consideration.