III. Loan Loss Provisioning

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1 III. Loan Loss Provisioning 35 35

2 Agenda» Loan Loss Provisioning a key to a true and fair view in bank accounting and prudent banking supervision» Incurred Loss Model of IAS 39 The Model Shortcomings» Expected Loss Model (IASB ED/2009/12) The Model Application challenges» Accounting Impairment vs. Expected Loss in Basel II 36 36

3 Loan Loss Provisioning» Key for a faithful presentation in the Accounts of Banks» Key for Bank Accounts as a sound basis for banking supervision purposes» Inherent trade off as Loan Loss Provisioning should lead to a reliable measurement of financial assets (loans) not over estimate financial assets (loans) not result in hidden reserves lead to a timely recognition of risk provisioning» In addition Loan Loss Provisioning should have a countercyclical effect from a stability point of view 37 37

4 Incurred Loss Model of IAS 39 The Model (1)» Impairment Identification for Financial Instruments at cost» At each balance sheet date, financial assets or group of financial assets to be tested for objective evidence of impairment (IAS and.59)» Impairment measurement No Loan Loss Provisions at initial recognition (day one) Financial Instruments that are individually significant - testing for objective indication of impairment - testing for actual impairment individually Otherwise testing for actual impairment collectively (portfolio basis)» To be recognised it is necessary that there is objective evidence of impairment; that impairment-events have arisen after issuance (trigger events IAS 39.59) 38 38

5 Incurred Loss Model of IAS 39 The Model (2)» Impairment measurement calculation of specific impairment (IAS 39.63, AG84) Impairment loss as the difference between carrying amount and discounted value of the estimated future cash flow using the original effective interest rate Effective interest rate on variable-rate financial instruments is the current contractual effective interest rate Short-term receivables are not discounted if the resulting effect is immaterial Valuation at current market price permissible as a simplification measure» Impairment loss to be included in profit and loss 39 39

6 Incurred Loss Model of IAS 39 The Model (3) objective evidence of impairment (trigger events) individually significant indication not individually significant no indication test of actual impairment individually impairment no impairment collectively impairment individually collectively 40 40

7 Incurred Loss Model of IAS 39 The Model (4)» Impairment measurement calculation of portfolio value Financial assets are grouped due to similar credit risk characteristics (IAS 39.AG87) IAS 39.59(f) observable data indicate that there is a measurable decrease in the estimated future cash flows Future cash flow to be calculated from historical default rates adjusted for current market conditions (IAS 39.AG89)» According to IAS 39, an allowance for collective (portfolio) impairment on a performing portfolio has to be established for incurred but not (yet) reported losses Formula-based approaches or statistical methods may be used for calculation (IAS 39.AG92) Similarities to Basel II EL calculation possible Formula need amongst others Loss Identification Period (LIP-Factor) EL = (Carrying Amount Collateral) x PD x LIP 41 41

8 Incurred Loss Model of IAS 39 Shortcomings» Expected losses not recognised before trigger events occur» Overstatement of interest revenue before trigger event (front-loading)» Does not reflect the underlying economics of the transaction» Triggers inconsistently applied in practices» Loss recognition too late» During the financial crisis there has been clear evidence that IAS 39 incurred loss model resulted in delayed loss recognition and has a cyclical effect 42 42

9 Forward Looking Provisioning» G 20 request (April 2009 London Summit) We agree [ ] to call on the accounting standard setters to work urgently with supervisors and regulators to improve standards on valuation and provisioning and achieve a single set of high-quality global accounting standards We have agreed that accounting standard setters should [ ] strengthen accounting of loan-loss provisions by incorporating a broader range of credit information Strengthened regulation and supervision must [ ] dampen rather than amplify the financial and economic cycle In future, regulation must [ ] require buffers of resources to be built up in good times 43 43

10 Expected Loss Model (IASB ED/2009/12)» June 2009: Request for Information Impairment of Financial Assets: Expected Cash Flow Approach (Expected Loss Model)» 5 th November 2009 ED/2009/12 (phase 2 of IAS 39-Replacemet Project) Financial Instruments: Amortised Cost and Impairment» Establishment of Expert Advisory Panel» Comment deadline: 30 th June 2010» Final Standard: 2010» Application: 2013? (around 3 years after final standard) 44 44

11 Expected Loss Model (IASB ED/2009/12) The Model (1)» Main outcomes of the ECF approach Single impairment model to be used Earlier recognition of impairment losses Eliminates front loading of interest revenue Better reflects underlying economics (e.g. pricing of instruments when lending decision is made)» Main features of the ECF approach Interest revenue is recognised on the basis of expected cash flows (including initial expected credit losses) Impairment results from an adverse change in credit loss expectations Reversal of impairment loss when expectations change favourably Re-estimation of expected cash flows each period 45 45

12 Expected Loss Model (IASB ED/2009/12) The Model (2)» Objective: To improve the accounting for provisions for losses on loans taking into consideration expected losses, resulting in more timely recognition of losses To reflect the economic reality of lending by recognising interest revenue as a credit cost adjusted return, which eliminates the frontloading of interest revenue» Scope: The requirements of the ED shall be applied to all items within the scope of IAS 39 that are measured at amortised cost 46 46

13 Expected Loss Model (IASB ED/2009/12) The Model (3)» The Expected Loss Model requires to determine the expected credit loss on the financial asset when that asset is first obtained to recognise contractual interest revenue, less the initial expected credit losses, over the life of the instrument to build up a provision over the life of the instrument for the expected credit loss to reassess the expected credit loss each period to recognise immediately the effects of any changes in credit loss expectations 47 47

14 Expected Loss Model (IASB ED/2009/12) The Model (4)» Measurement Principles Amortised cost shall be calculated using the effective interest method. Hence, amortised cost is the present value calculated using - the expected cash flows over the remaining life of the financial instrument - the effective interest rate as the discount rate The estimate for the cash flow inputs are expected values. Hence, estimates of the amounts and timing of cash flows are the probability-weighted possible outcomes 48 48

15 Expected Loss Model (IASB ED/2009/12) The Model (5)» Amortised cost is the amount at which a financial asset is measured at initial recognition adjusted over time as follows minus principal repayments plus or minus the cumulative amortisation using the effective interest method of any difference between the initial amount and the maturity amount plus or minus any addition or reduction resulting from the effect of revising estimates of expected cash flows (e.g. regarding prepayments or uncollectibility) at each measurement date» The estimate of expected cash flows has to consider All contractual terms of the financial instrument (e.g. prepayment, call or similar options) Credit losses over the entire life of the asset 49 49

16 Expected Loss Model (IASB ED/2009/12) The Model (6)» Presentation The statement of comprehensive income shall inter alia include the following: Gross interest revenue ( = contractual interest revenue) - Initial expected credit losses (portion allocated to the period) = Net interest income revenue ( = economic interest revenue) Gains and losses resulting from changes in credit loss expectation 50 50

17 Expected Loss Model (IASB ED/2009/12) Application Challenges» Establishment of a Expert Advisory Group Advise the Board on how operational challenges of the ECF approach might be solved Assist in field testing» Extensive outreach activities» Many practical issues in applying the new impairment rules have to be solved 51 51

18 Accounting Impairment vs. Expected Loss in Basel II» Time horizon IASB / Accounting: Lifetime of the financial instrument Basel / Supervision: one-year PDs» Calculation base IAS 39: focus on categories at amortised cost; different methods Basel II: investment book; EL = EAD x LGD x PD» Default definition IAS 39.59: trigger events Basel II: debtor is unlikely to pay / 90 day past due» Interest rate Basel: no reflection IAS 39: relevance of effective interest rate» Common use of data base seems to be possible 52 52

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