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 about event More on this topic

Past Event

Past Event

Designing a new institutional framework for UK-EU relations

Finding the right way forward for the EU and the UK.

Speakers: Raphael Hogarth, Jill Rutter and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: July 13, 2018
Read article More on this topic More by this author

Opinion

Griechenland braucht einen Neuanfang

This was first published by Die Zeit. Acht Jahre nach Beginn des ersten Hilfsprogramms für Griechenland ist es soweit – Griechenland soll wieder auf eigenen Füßen stehen. Die Eurogruppe soll heute das Ende des dritten Hilfsprogramms beschließen und die Modalitäten für die Zeit danach definieren. Ziel sollte es jetzt sein, einen tragfähigen Ausstieg aus dieser für alle Seiten […]

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: July 3, 2018
Read article More on this topic More by this author

Podcast

Podcast

Director's Cut: The drama of the EU and euro area

Bruegel's director, Guntram Wolff, is joined by Ashoka Mody, visiting professor in international economic policy at Princeton University to discuss topics from his latest book, Euro tragedy: a drama in nine acts.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: June 27, 2018
Read article More on this topic More by this author

Blog Post

The Meseberg declaration and euro-zone reform

The recent Franco-German Meseberg declaration will set the scene for next week’s summit. We review opinions on this important agreement.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: June 25, 2018
Read article Download PDF More on this topic More by this author

Working Paper

EU financial services policy since 2007: crisis, responses and prospects

This paper presents a holistic overview and assessment of the European Union (EU)’s financial services policy since the start of its financial crisis in mid-2007. Its emphasis is on public policy initiatives and developments at the European level, including those specific to the euro area.

By: Nicolas Véron Topic: Finance & Financial Regulation Date: June 21, 2018
Read about event More on this topic

Past Event

Past Event

For a stronger and more integrated Europe

This event will feature the presentation of the Economic Survey of the European Union 2018 and Economic Survey of the Euro Area 2018.

Speakers: Angel Gurría, Zsolt Darvas, Pierre Beynet and Aida Caldera-Sanchez Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: June 19, 2018
Read article More on this topic

Blog Post

The G7 is dead, long live the G7

The summit in Charlevoix left behind a Group of Seven in complete disarray. The authors think that the G-group, in its current formulation, no longer has a reason to exist, and it should be replaced with a more representative group of countries. In this fast-changing world, is the G7 only a relic of the past?

By: Jim O‘Neill and Alessio Terzi Topic: Global Economics & Governance Date: June 13, 2018
Read article More on this topic More by this author

Opinion

« Mieux vaudrait laisser les gouvernements libres de tenter les politiques de leur choix »

Les peuples ont le droit de faire des erreurs: Selon l’économiste Jean Pisani-Ferry, l’Union européenne doit accepter les aspirations légitimes à des politiques disparates, tout se prémunissant contre la contagion de leur corollaire : la possibilité d’une faillite souveraine.

By: Jean Pisani-Ferry Topic: European Macroeconomics & Governance Date: June 12, 2018
Read article More on this topic

Blog Post

Is the ECB collateral framework compromising the safe-asset status of euro-area sovereign bonds?

Central banks’ collateral frameworks play an important role in defining what is considered as a safe asset. However, the ECB’s framework is unsatisfactory because it is overly reliant on pro-cyclical ratings from credit rating agencies, and because the differences in haircuts between the different ECB credit quality steps are not sufficiently gradual. In this note, the authors propose how the ECB could solve these problems and improve its collateral framework to protect its balance sheet without putting at risk the safe status of sovereign bonds of the euro area.

By: Grégory Claeys and Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: June 8, 2018
Read article More on this topic More by this author

Opinion

Trägt Deutschland eine Mitschuld an Italiens Krise?

Italiens Regierung will riesige neue Schulden machen – die nächste Bewährungsprobe für die Eurozone. Deutschland muss sich aktiv an der Lösung beteiligen.

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: June 6, 2018
Read article More by this author

Podcast

Podcast

Director's Cut: Central banking and the problem of unelected power

Bruegel director Guntram Wolff discusses current tensions in central banking governance with Paul Tucker, former deputy governor of the Bank of England and author of the newly released book 'Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State'.

By: The Sound of Economics Topic: Finance & Financial Regulation, Global Economics & Governance Date: June 5, 2018
Read article More on this topic More by this author

Opinion

Mattarella’s line in the sand

The vital task confronting Europe is to reconcile citizens’ right to make radical choices with the need to ensure that decisions leading to constitutional change are subject to sufficient public deliberation. The EU and the euro must not be constitutional cages; but nor should they be subject to ill-considered decisions.

By: Jean Pisani-Ferry Topic: European Macroeconomics & Governance Date: June 1, 2018
Load more posts