Blog Post

Accounting for true worth: the economics of IFRS9

The introduction in 2018 of forward-looking provisioning for credit losses in EU banks delivers on a key objective in the post-crisis regulatory agenda. This was intended to dampen future lending cycles. For now, banks will be sheltered from the impact on regulatory capital requirements, as the implications for financial stability are far from clear. In any case, the new standards should encourage the disposal of banks’ distressed assets, underpinning the ongoing agenda on NPLs.

By: Date: November 13, 2017 Topic: Finance & Financial Regulation

As one of the final items in the post-crisis regulatory agenda, IFRS9 will come into effect for financial institutions across the EU in 2018. The new accounting framework delivers on the ambition of G20 governments in 2009 to dampen pro-cyclical lending as banks put in place more substantial provisions against credit losses, and do so earlier in the credit cycle.

The regime to date has been one of ‘incurred credit losses’. Only once a bank had observed an actual credit event, such as a loan default, would it need to set aside reserves for the ultimate loss. Banks tended to smooth income through provisions, re-enforcing cyclical swings.

Provisions ahead of the financial crisis were clearly “too little too late”. Even as risks built up, capital requirements were largely unaffected. The Bank of Spain was one of very few supervisors to implement countercyclical general provisions, though these ultimately proved inadequate. Once the crisis set in, provisioning models forced a sharp adjustment.

IFRS9 now represents a fundamental regime change, as banks will need to anticipate losses. Where a loan is already classed as defaulted, the losses expected over the entire remaining lifetime will need to be set aside. This should help converge provisioning levels which are still widely different across Europe, reflecting often protracted procedures in enforcement and foreclosure.

Provisioning coverage of NPLs in Europe

Source: EBA Risk Dashboard, Q2 2017.

But there is an important stock of loans in Europe’s banks that are questionable but not yet covered in the NPL data. These would be classed as under-performing, but have periodic payment delays of less than 3 months. There would be some probability of default, and a deeper analysis may even reveal an enterprise as not viable. Under the new regime losses over the coming year will need to be provisioned for all loans, and once there is a payment delay of more than a month, losses expected over the entire remaining lifetime of the loan need to be booked. This will force early recognition of credit losses, and likely give stronger incentives for financial restructuring of debt-distressed borrowers.

European banks seem on the whole ill-prepared for this change. Impact assessments that were based on survey responses, such as the EBA’s in July, find a sizable need for additional provisions which may need to increase by 20 to 30 per cent. Capital coverage could fall by about half a percentage point. Smaller banks especially in the high NPL countries are likely to be more severely affected. The calculation of capital requirements based on internal models, which the EU has vigorously defended, will give more flexibility but it is not normally employed by smaller institutions with a less complex asset structure.

Even though this change has been expected ever since the finalisation of the standards in 2014, the Commission nevertheless now fears a sudden impact on bank capital ratios. Part of its so-called banking reform package of late 2016 have just been agreed and put in place a lengthy transition period. This seems to have been informed by a report by the ESRB and additional analysis earlier this year. This demonstrated that the potential concentration of capital losses at the point when the economic outlook deteriorates may in fact amplify, rather than reduce, variability in capital and hence lending over the cycle. It will be some time before discipline in credit loss recognition will be reflected in capital requirements.

New ECB standards

The implementation of the IFRS should not be confused with the recent initiative by the ECB to further tighten its guidelines on banks’ management of non-performing loans. Under this proposal NPLs newly emerging from 2018 would need to be provisioned for the unsecured component within two years, and fully provisioned after seven years. This would be under the ECB’s powers as euro area supervisor, and the Council’s action plan on NPLs asked the Commission to implement a similar change within the capital regulation.

This change would clearly further raise provisioning needs beyond those already under way through the IFRS. It would only apply to new NPLs for which the inflow is already much reduced, and it would be limited to the largest euro area banks that are under direct ECB supervision. Several countries expressed concerns over the implications for loan pricing. The change would affect those loans that iterate between non-performing status, forbearance and restructuring, and it would likely ultimately also be reflected in the supervision of smaller banks.

The new accounting rule changes will bring loan loss provisions forward. Once this is fully reflected in capital requirements, the resulting dampening of the loan cycle is to be welcomed. Yet, an individual bank’s capital position will depend on the model used to estimate future credit losses and collateral recovery, and provisions will be sensitive to the macroeconomic scenario that was assumed. It will be hard to compare banks’ models but we should expect a downturn in the economic outlook to lead to a contraction in lending much sooner than used to be the case.

Both IFRS9 and the proposed changes in ECB guidelines would bring banks’ net book values of loans more into line with the valuation of investors who may acquire such assets. Romania in 2013-15 demonstrated how more forceful provisioning requirements can kickstart a process of asset separation and develop an NPL market. This is clearly the ambition in the Council’s action plan and may well be the result of the more intrusive supervision of high NPL banks by the ECB.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Blog Post

A slightly tighter ECB

The ECB’s recent decision on QE was somewhat on the dovish side. Francesco Papadia gives his view on why it is time to start a discussion about reducing the degree of ease of monetary policy.

By: Francesco Papadia Topic: European Macroeconomics & Governance Date: November 15, 2017
Read article More on this topic

Blog Post

The Eurosystem - Too opaque and costly?

The Eurosystem gets a lot of attention from academics and the media, but they largely focus on its statutory objective of maintaining price stability. There is much less interest in its transparency and operational efficiency. We analyse these issues, and find that the Eurosystem is less transparent and operates with significantly higher costs and headcount than the US Federal Reserve System.

By: Francesco Papadia and Alexander Roth Topic: European Macroeconomics & Governance Date: November 6, 2017
Read article More on this topic More by this author

Blog Post

Euro-area enlargement: a new opening?

8 of the EU27 have not yet joined the Euro, and progress in euro-area enlargement seems to have stalled. Commission President Juncker wants to give new momentum to the process, but the path is full of political and technical hurdles. The Euro is unlikely to have any new members soon.

By: Marek Dabrowski Topic: European Macroeconomics & Governance Date: November 2, 2017
Read article Download PDF More on this topic

Policy Brief

The time is right for a European Monetary Fund

Two of the banking union’s pillars – common European supervision by the European Central Bank and common European resolution by the Single Resolution Fund – are up and running. But the third, common European deposit insurance, is still missing. The authors propose to design the EMF as part of a broader risk-sharing and market-discipline agenda.

By: André Sapir and Dirk Schoenmaker Topic: European Macroeconomics & Governance Date: October 30, 2017
Read article Download PDF More on this topic More by this author

Policy Contribution

The missing pieces of the euro architecture

What are the remaining fragilities of the Euro architecture? This policy contribution assesses the institutional reforms put in place during and after the crisis and make some proposals for a coherent economic governance framework to make Europe’s monetary union more resilient.

By: Grégory Claeys Topic: European Macroeconomics & Governance Date: October 26, 2017
Read article More on this topic

Blog Post

Phillips vs. Pass-through, or the changing ECB understanding of inflation

This blog post looks at how the approach of the ECB to inflation has changed over the years. It shows the ECB has moved, over the years, from a small towards a large country approach, giving more weight to the improving employment conditions than to the appreciating exchange rate in deciding its monetary policy moves.

By: Francesco Papadia and Alessandra Marcelletti Topic: European Macroeconomics & Governance Date: October 25, 2017
Read article

Blog Post

An update: sovereign bond holdings in the euro area – the impact of quantitative easing

Since the European Central Bank’s announcement in January 2015 of its quantitative easing programme, national central banks have been buying government and national agency bonds. In this post we look at the effect of QE on sectoral holdings of government bonds, updating calculations that we published initially in May 2016.

By: Pia Hüttl and David Pichler Topic: European Macroeconomics & Governance Date: October 10, 2017
Read article Download PDF

External Publication

European Parliament

The single monetary policy and its decentralised implementation: An assessment

This paper assesses the decentralised implementation of monetary policy by the Eurosystem in terms of its transparency, efficiency and simplicity. Compared to the Fed, the Eurosystem seems to have higher staff numbers and operational costs for similar tasks.

By: Francesco Papadia and Alexander Roth Topic: European Macroeconomics & Governance, European Parliament, Testimonies Date: October 4, 2017
Read article Download PDF More by this author

External Publication

An innovation deficit behind Europe’s overall productivity slowdown?

Reinhilde Veugelers' chapter in "Investment and Growth in Advanced Economies", conference volume of the European Central Bank’s Forum on central banking in Sintra.

By: Reinhilde Veugelers Topic: European Macroeconomics & Governance, Innovation & Competition Policy Date: October 2, 2017
Read article More by this author

Opinion

A Jamaican Germany is good for Europe

After a surprising election result, Europe is closely watching German coalition negotiations. A so-called Jamaica coalition of conservatives, liberals and greens is the most likely outcome, but many fear this will be bad for the EU and the Eurozone. Not so, argues Guntram Wolff. In fact, a shift to Jamaica could be good news for Europe.

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: September 29, 2017
Read article More on this topic

Blog Post

Employment in Europe and the US: the EU’s remarkable strength

The common narrative that the US labour market outperforms the EU is not as trustworthy as overall unemployment figures imply. There is a complex interaction between job creation, labour force participation and unemployment. Jobseekers leaving the labour market altogether was an important factor behind the reduction in US unemployment, while Europe’s job growth has been accompanied by increased labour force participation.

By: Zsolt Darvas and David Pichler Topic: Global Economics & Governance Date: September 28, 2017
Read article Download PDF More on this topic

Policy Contribution

A European perspective on overindebtedness

The sequence of crisis and policy responses after mid-2007 was a gradual recognition of the unsustainability of the euro-area policy framework. The bank-sovereign vicious circle was first observed in 2009 and became widely acknowledged in the course of 2011 and early 2012. The most impactful initiative has been the initiation of a banking union in mid-2012, but this remains incomplete and needs strengthening.

By: Nicolas Véron and Jeromin Zettelmeyer Topic: European Macroeconomics & Governance Date: September 28, 2017
Load more posts