Loan value rules will blast hole in bank capital

The new rules, intended to make banks recognise balance sheet problems earlier, will make bank capital much more vulnerable in times of stress, advisors are warning.

Once the economic environment begins to deteriorate, banks could see huge swathes of their banking book assets, usually held at par if the bank does not expect a loss within a year, revalued to take account of the expected loss through the lifetime of the loan.

“Accounting values will be highly volatile and pro-cyclical ,” said a note from the FIG advisory team at BNP Paribas, led by Adrian Docherty. “In stress tests and at the onset of crises, banks will see provisions volatility doubling, resulting in major, early hits to their equity. They will need to have much more equity to absorb this volatility.”

Docherty described the changes as “bigger than Basel”.

Any expected future income from the loan cannot be used to offset the loss – meaning an upfront hit to equity.

The change is a fundamental rewrite to the philosophy of bank reporting, prompted by the experience of financial crisis – banks with apparently healthy capital ratios could fail abruptly, because their assets were valued according to losses incurred, not expected future losses.

Angel Mozon , policy expert at the European Banking Authority, said: “We’re aware that IFRS 9 and, in particular, the new expected loss model may have an impact on capital, and we will monitor this, and also analyse further the interaction between IFRS 9 and prudential regulation.”

Reforms to accountancy standards, known as IFRS 9, will change the way banks value their loan book. Instead of good loans and bad loans, the new rules add a third category in between – loans which are no longer as good as at origination.

For loans in the new, intermediate category, banks will have to calculate the expected lifetime loss of the loan, rather than recognise the one year expected loss (as in good loans) or use the impaired loan loss calculation (which remains similar to the previous IAS 39 standard).

The FIG team at BNP Paribas said that reported bank equity levels could fall by 10%-20%, while in some cases, in recessionary countries, banks could see their entire equity base wiped out.

The big uncertainty is over which loans end up moving from “stage 1” – the IFRS category of good loans – to the new, intermediate stage 2 category.

BNPP’s team quote a study from Deloitte, published this year, which shows global banks expect loan loss provisions to increase by between 0%-50%. S&P said US bank core tier one levels would drop by 3% if provision levels doubled.

Accountancy firm KPMG said the rules “may result in a large negative impact on equity for banks and, potentially, insurance and other financial services entities.”

“IFRS 9 loan impairment rules are going to be of key importance – it will place the bank’s asset impairment provisions on different playing field to where they are now,” said Alan Chapman, head of financial instruments reporting at Grant Thornton. He explained that the expected credit loss model meant losses would be recognized earlier.

While IFRS 9 means a one-off hit to equity for banks in ordinary times, the real danger could arise in tougher times.

Because a bank will have to recognise all expected future losses up front, a small change now – poor macro numbers, political changes or similar – could force a bank to take a big provision, weakening its equity base at the exact moment when the market could be turning anyway.

“For high risk banks in normal markets and all banks in high risk markets, the one-off application of IFRS 9 could annihilate the entire regulatory equity base,” said the BNP Paribas team. “There is a chance that virtually all of the loan book in such circumstances could move to Stage 2. Loans with an annual expected loss of say 1% could require a lifetime expected loss of say 6%, reducing the net accounting equity by 5% of assets. This is the same level as a typical pre-IFRS 9 leverage ratio.”

The note continued, saying: “Such a hypothetical hit would reduce equity capital ratios to around zero.”

Grant Thornton’s Chapman, however, had a different take.

“I’d say IFRS 9 it is less procyclical than IAS 39 [the previous accounting framework for UK banks], which would have the same effect on provisions, but at a later stage,” he said. “The earlier you realise that lending was unduly optimistic and losses are expected, the better.”

BNP Paribas also argue there would be an impact on banks’ cost of equity – despite the fact that nothing will change in the real world.

Even if the one-off impact on equity is manageable, the provisions which banks take will definitely become more volatile – meaning equity investors will not get such a stable dividend.

“There is little science behind cost-of-equity, but we would hazard a guess that it could rise by some 20%, as banks move away from their desired ‘utility-like’ low volatility return expectations,” said the BNP Paribas team.

Regulators have been pushing hard to force banks to standardise the way they assess the riskiness of their assets, by cracking down on the internal ratings based approach and introducing a leverage ratio, which does not adjust for the riskiness of assets at all.

Accounting values of assets feed into regulatory capital numbers – but modified by the “prudential filters” which supervisors apply.

IFRS 9, however, adds uncertainty back into the calculation. Banks will have considerable discretion to determine which assets move into Stage 2 and when, and will likely come out with different results.

“There are a number of key principles in IFRS 9, but no single right answer for when a bank should categorise as stage 1 or stage 2, or exactly how it should model lifetime expected loss,” said Grant Thornton’s Chapman. “Banks need strong governance and procedures around this, and enough disclosure around its assumptions. ”

The Basel Committee called for banks to “disclose how forward-looking information and macroeconomic factors have been factored into and have affected these expected credit loss measurements” in a consultation paper issued this year.

BNP Paribas’ team, however, are pessimistic about how investors will be able to use this data.

“Investors have proven unable adequately to utilise banks’ Pillar 3 disclosures on Internal Ratings Based Approach risk weights – they are unlikely to be able to scrutinise the new IFRS 9 disclosures and hence will not be able to use accounting numbers from the financial statements with confidence,” said the BNP Paribas note.

It continued: “This is exacerbated by the fact that basic accounting data – such as net income – will move from fairly comparable to completely uncomparable. Accounting information will have failed in its main objective of providing meaningful supporting information to investors’ decision processes.”

Grant Thornton’s Chapman said: “The Basel Committee and European bodies will try to maximise comparability. Investors and auditors won’t want local regulators taking inconsistent approaches leading to a lack in comparability, they’ll want a consistent view if possible.”

Mostly, though, regulators seem to be welcoming IFRS 9, despite the possible hit to equity levels.

“It’s finally bringing accounting into line with the prudential and supervisory view,” said a source familiar with the thinking of the ECB’s Single Supervisory Mechanism. “Some banks will face capital issues, but this very much depends on the phase-in process.”

The person argued that although it could be procyclical in some circumstances, it could also act as a countercyclical stabilizer in other circumstances.

“The ECB is not of the opinion that nothing will happen – it clearly isn’t just one more regulation,” said the person. “But a more creeping process of phasing in should be sufficient to avoid damage. The ECB will likely monitor it closely.”

The European Banking Authority said that the forward-looking nature of the provisions was a strength.

It said in a letter to Roger Marshall, the president of the European Financial Reporting Advisory Group, that the EBA “supports the movement from an ‘incurred’ to an ‘expected’ credit loss model which should result in the earlier recognition of credit losses. In this respect, IFRS 9 is expected to address some prudential concerns and contribute to financial stability”.

But the EBA also drew attention to areas where regulatory capital rules might need to be changed to fit in with the new accounting plan.

Banks which use the internal ratings based approach – using their own models to judge asset risk – can compare their accounting provisions with regulatory provisions, feeding any excess into tier two capital, and deducting any shortfall from common equity tier one.

The EBA said: “It should be considered if and to what extent the regulatory framework…should be revised in light of the interaction with IFRS 9.”

For now, the EBA is monitoring the situation, arguing it is too early to start contingency planning, or discuss overhauling regulation. By next year, however, things should be different.

Mozon , the EBA’s policy expert, said: “It’s too early to calculate the final numbers – we have had some discussions with banks and received qualitative feedback but it seems that there isn’t really reliable quantitative information yet. There should be more quantitative information available next year, and from our perspective we’ll see if and to what extent any revision in the regulatory framework is needed.”

BNP Paribas’ team argue: “We simply don’t know whether regulators are going to keep current solvency requirements as-is, once the accounting numbers, on which solvency assessments are made, change drastically. One would assume that many of the features of Basel III – capital conservation buffers, Pillar 2, stress test pass marks and the like – would need to be rethought in the light of IFRS 9 adoption.”

The rules are set to come in from January 2018, giving banks two and a half years to prepare. But reporting for the year 2018 will need to incorporate 2017 data, rebased to IFRS 9, to be comparable, meaning prudent banks will want to get ahead and start making expected loss calculations from the beginning of 2017.

“Despite the January 2018 mandatory application of IFRS 9, 87% of banks plan to perform a parallel run during 2017,” said the BNP Paribas team, citing Deloitte’s research. “Already in 2015, all parties should make sure that they are at least aware of the importance of IFRS 9 and the fact that it is not an accounting tweak – it has profound strategic consequences.”

Simply getting ready for this deadline will be a problem for some institutions, particularly smaller financial institutions which do not already use the Basel Internal Ratings Based approach. Basel IRB is a different calculation for a different purpose, but it has similarly challenging modelling requirements.

The EBA’s Mozon said: “Banks have three years to prepare, and some will be able to leverage on the experience and data they’ve already collected for IRB models.”

Grant Thornton’s Chapman said: “This will be a substantial challenge for the major banks, but potentially even more so for the challenger banks and smaller institutions, in terms of getting resources and preparations for this. The resource required for IFRS 9 could act as a barrier to entry in the market. A key driver impacting the amount of effort required will depend on the nature of the bank’s products and the sensitivity to credit risk.”