Banks may have to provision for expected losses rather than waiting for losses to actually occur

By Gareth Vaughan

Local banks face having to provision for expected loan losses rather than waiting for losses to actually occur in a shake-up being proposed to international accounting standards.

In a move that comes as a reaction to the Global Financial Crisis (GFC), the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board of the United States are proposing changes whereby banks would be required to book losses on loans when they expect a loss to occur but before it actually eventuates, rather than waiting for a loan default to occur.

Currently International Financial Reporting Standards (IFRS) and US Generally Accepted Accounted Principles (GAAP) account for credit losses using an incurred loss model, which requires evidence of a loss (known as a trigger event) before financial assets can be written down. However, the proposed change would see a move to an expected loss model that provides a more forward-looking approach to how credit losses are accounted for, which the international accounting bodies argue better reflects the economics of lending decisions.

Kevin Simpkins, chairman of the New Zealand Accounting Standards Review Board, said the international bodies were striving to finalise any changes by June 30 this year as part of a Group of 20 (G20) deadline on GFC responses. Simpkins said he expected New Zealand to adopt the changes "in whatever form is finalised" by July.

'Slight step up'

PricewaterhouseCoopers partner Sam Shuttleworth told interest.co.nz that the incurred loss approach was "point in time provisioning" whereas the expected loss model was more of a "through the credit cycle approach." Shuttleworth said, however, that he didn't expect the adoption of an expected loss model would lead to a significant rise in the dollar value of provisioning by New Zealand banks.

"Possibly there’ll be a slight step up," said Shuttleworth.

He said the proposal is for a dual impairment model driven by the characteristics of the financial assets. This is consistent with how banks manage credit risk and is sometimes referred to as a "good book" and "bad book" approach.

Impairment of financial assets in the good book will be recognised on a portfolio basis over the life of the book with the allowance account the higher of the time proportionate expected credit losses or the credit losses expected to occur within the foreseeable future but not less than 12 months.

As for the bad book, here the entire amount of the lifetime expected credit losses will be recognised immediately.

"The method of calculation will change but I don’t think it will result in a materially different collective provision number for the New Zealand banks. Where it’s probably going to have a greater impact will be in the Northern Hemisphere I suspect," Shuttleworth said.

Back to the future

Shuttleworth noted that before the recent introduction of IFRS the expected loss model had been the basis for calculating a provision. However, IFRS shifted to to an incurred loss basis.

"Now this is doing a 360 and reverting back."

He said of the two types of provisioning banks undertake - specific provisioning and collective provisioning - it'll be the latter that changes under the return to an expected loss model.

"The collective provision is providing for losses that have occurred but not been identified and the specific provision is to provide for those loans that you know have gone bad and you’re providing for loss now," said Shuttleworth.

Sir David Tweedie, chairman of the IASB, says a major complaint in the GFC was that when loan losses were recognised, it was a case of "too little, too late."

"Such a situation highlighted the need for a more-forward looking approach to loan losses to ensure provisions are made much earlier than before," said Tweedie.

"The proposed move to an expected loss model will address this issue, in addition to aligning IFRS and US GAAP."

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