Safer banks, fewer loans?

In less than two years, banks have undergone a profound transformation in the way in which they deal with problem loans.

The dry-sounding IFRS 9 - an International Financial Reporting Standard - came into force on 1 January 2018. Developed by the International Accounting Standards Board (IASB), the new standard aimed to fix the flaws in bank regulation exposed by the 2007-2008 financial crisis.

It requires banks to hold more capital and safeguard against the danger of loan defaults.

No reasonable person, recalling the horrors of 10 years ago and the subsequent enormous bills handed out by the banking industry to taxpayers on both sides of the Atlantic, could object to this pursuit. There was much that was wrong with the previous system of provision against sour loans.

But there are always trade-offs involved in attempts to make banks safer and more resilient and the costs of such trade-offs have to be borne by the various stakeholders involved.

The new standard

IFRS 9 was designed to address a central weakness of the pre-crisis rules. This was that capital requirements, while strictly speaking identical in good and bad times, were backward-looking in nature, effectively making them lighter during good times and more burdensome during a downturn.

The previous system required banks to calculate the level of provisions needed once the loans in question had defaulted or were about to do so.

Under this so-called ‘incurred loss’ arrangement, provisioning was essentially backward-looking, requiring banks to take action with regard to what had happened in the immediate past rather than what was expected to happen in the near future. This meant that, since little needed to be done in terms of capital buffers, as long as the economic sun was shining the banks were effectively encouraged to lend more aggressively.

When the boom in the mid-2000s ended and borrowers started defaulting, the rules required lenders to make provisions against the now defaulting loans. This crisis forced banks to turn off the taps in order to ensure capital adequacy, worsening the crisis all round and contributing to the largest credit crunch in recent history.

IFRS 9 replaced the ‘incurred loss’ concept with one of ‘expected loss’, also known as ‘expected credit losses’, a forward-looking rather than a backward-looking regime.

The idea is that it will curb over-exuberant lending practices in the good times, lay up a store of capital to meet loan losses in the bad times and obviate the need for a credit squeeze that will only deepen the scale of any downturn.

The new rules have created big changes in bank operations, and everyone in banking – from the boards of directors to the tellers in the branches – are aware of them. But, to put it bluntly, was introducing them a good idea? Before answering that question, a little history is in order.

Hostility to change

In the run-up up to the crisis, bank regulators had been advocating just such a rule change, but had encountered resistance from two quarters: the accountancy profession and the banks themselves.

Accountants generally disliked the switch from ‘incurred’ to ‘expected’ losses because of what they saw as a loss of objectivity. Calculating incurred losses was relatively straightforward because the losses in question had either occurred or were imminent.

There was little room for interpretation, argument or manoeuvre.

By contrast, they argued, the notion of expected losses gave the banks too much discretion, given that ‘expectations’ are often in the eye of the beholder and create more scope for human bias and error.

Meanwhile, the banks feared the impact on their balance sheets of having to make provisions against loans that might or might not default. What was more, such a regime would not allow for the recognition of loans that were admittedly high risk but also high reward. This, they argued, would result in the system demanding higher levels of provision right across the business cycle, not just during the good times.

After the crisis, the accountants effectively threw in the towel, reckoning that they could live with a little more discretion for the banks if that was the price of curbing the pro-cyclicality that had brought the system to its knees. Banks were in no real position to offer further resistance, being seen by many, rightly or wrongly, as villains of the piece – although, ironically, some of their objections did have some justification.

What's different now?

When IFRS 9 came into force almost two years ago, banks published two sets of balance sheets side by side – one laying out the position on December 31 2017, the second showing the position a day later. Given that nothing had changed other than IFRS 9, this captured perfectly the one-off impact of the new rule.

This impact was, as the banks had feared, largely negative. The effect on Tier One capital ratios (the ratio of a bank’s core equity capital to its total risk-weighted assets) was reported at the time to have been about 80 to 100 basis points, so, for example, a bank holding a ratio of 12% would see their ‘slack’ over the 8% minimum capital requirement fall from 4% to 3%.

In an assessment ahead of the changes, published in July 2017, the European Banking Authority (EBA) had suggested a ‘negative day-one impact’ on Tier One capital of 42 basis points, and, in December last year, after a review of the operation of IFRS 9, calculated the effect at 51 basis points.

The increase in provisions, the EBA found, had been 9%, lower than the 13% estimated in the July 2017 assessment.

It added: “The post-implementation review of IFRS 9 is just starting and the effective impact of the standard, closely linked to the current and expected macroeconomic circumstances, as well as its implementation, will need to be reviewed through time.”

Does all this matter? Yes, quite possibly, in terms of the sort of loans that may not now be made by banks anxious to shrink the ‘expected loss’ basis on which their capital requirements are calculated.

Such loans are likely to include those to small- and medium-sized enterprises and to individual borrowers considered to be at higher-than-average risk of default. Furthermore, the cost of loans in these categories that continue to be made may very well rise.

Then there is the question of loan maturities. Under IFRS 9, the potential loss on loans to a solid business or other ‘safe’ borrower needs to be calculated for 12 months ahead. But for riskier lending propositions, potential losses need to be calculated for the lifetime of the loan, with consequent repercussions on the provisions needed.

Under such circumstances, why would a bank advance five-year loans to such borrowers? In addition to the shortening of loan maturities, collateral requirements are likely to rise.

The net effect of these changes could be lower than expected investment with, consequently, a slower rate of growth in GDP. At the root of this, I believe, is an intentional or unintentional lack of communication between regulators charged with promoting growth and those whose prime function is to maintain stability.

Meanwhile, bank shareholders will be bearing the additional compliance costs and these costs may change, either up or down, in the wake of a current EBA ‘roadmap’, published in July 2019, for “monitoring activities on IFRS 9 implementation”. The agency wants to promote “a consistent application of IFRS 9 as well as working on the interaction with prudential requirements”.

It added: “The focus of this exercise is to assess whether the use of different modelling techniques and inputs can lead to significant inconsistencies in terms of the expected credit losses amounts that directly impact own funds and regulatory ratios.”

In jurisdictions found to be inconsistently lax compared with other states in the EBA’s purview, provisions by their banks may well have to be increased.

So far, we have concentrated on the downsides of IFRS 9. But nobody surveying the wreckage of the financial crisis would be likely to conclude that the pro-cyclicality of the old regime was in any way desirable. The big advantage of the new rules is that the financial system is better protected against future problems than it was in the past.

Counter-cyclicality means that bankers will have ‘taken the hit’ on their capital ratios before trouble arises, and will have in place provisions that should see them through tough times.

So yes, on balance, IFRS 9 is a good idea. But there are, and will always be, costs and trade-offs.

Aytekin Ertan is Assistant Professor of Accounting at London Business School