The new accounting standard IFRS-9 will have a dramatic impact on how banks provision for credit losses, leading the Basel Committee on Banking Supervision to consult on how to manage its effect on capital requirements. Justin Pugsley reports.

What is happening?

Banks could face a capital shock after 2018. That is the concern voiced by the Basel Committee on Banking Supervision, not about the capital requirements it is prescribing to banks, but the new accounting standards that are to come into force in January 2018.

The committee is particularly worried about one standard, IFRS-9, which will replace the existing IAS-39. IFRS-9 was a response to the financial crisis due to the belief that accounting standards had exaggerated it. A key weakness identified was the delayed recognition of credit losses.

Reg rage anxiety

Basically, the new approach changes how banks make provision for losses. At the moment, they recognise losses after they occur. But IFRS-9 is a forward-looking measure that will force banks to start estimating losses from when a loan is made and over the course of its lifetime, and will cover a broader spectrum of assets. In effect, it brings forward any bad news, which means anticipating the impact of events such as future recessions or big political events, and setting aside capital to cover potential losses.

This new accounting approach will have a very significant impact on banks as higher impairments deplete regulatory capital so there is less left over to distribute to shareholders and for staff bonuses.

Why is it happening?

Given the concerns over a potential capital shock for banks from provisioning for expected credit losses, the Basel Committee is proposing several options, including a three- to five-year phase-in period for the banks in adopting the new accounting rules. It is currently consulting on that topic.

And it seems there is a genuine cause for concern – particularly for European banks, many of which are struggling with non-performing loans. The European Banking Authority found that provisions rose by 18% on average under IFRS-9, and up to 30% for 86% of the banks that responded to a survey it recently carried out. Impairment requirements were responsible for much of the increase.

Deloitte found that the new standards could increase impairment charges across all asset classes by 25% for banks. Fitch Ratings, which welcomed Basel’s transitioning proposals, noted that the impact of expected credit loss accounting on regulatory capital ratios is unknown and in some cases could be significant.

And there are numerous surveys showing that banks are underprepared for the new standard.

What do the bankers say?

Given the very significant impact of IFRS-9, it is surprising that banks have not been far more vocal about it. After all, it not only has consequences for dividends and bonuses, but also for earnings, bank bonds and share prices – potentially making them a lot more volatile as provisioning becomes more dynamic.

So far, banks are doing their best to adapt to the new rules and a few will be running IFRS-9 reporting in their results in 2017 in parallel with the current standard. However, banks have argued that they still do not yet have enough information or guidance from regulators to fully understand the impact on capital and earnings, which is frustrating.

Also, it is possible that most of their energy, particularly from the European side, has been devoted to ensuring that the finalisation of Basel III does not result in another big leap in capital requirements.

Indeed, a big part of the Basel III battle is being fought over the use of banks’ internal models for measuring risk. The Basel Committee wants to limit the use of these where possible and instead get banks to use a standardised approach for risk measurement. However, under IFRS-9, the standardised approach will have an even bigger impact around loss provisioning – so winning the ‘models battle’ would provide some relief for European banks under IFRS-9.

Will it provide the incentives?

It is hard to say whether IFRS-9 will provide the right incentives. What is clear is that there is still a lot of uncertainty, and even confusion, over how the standard will interact with capital requirements, such as Basel III. What that means is that there are very likely to be unintended consequences, which is a source of concern in itself. So delaying (or even phasing in) the new standard seems to be a sensible idea. Also, regulators need to be more proactive in guiding banks on their implementation.

This is not just a matter of convenience for banks, but also their loan decisions and cost of capital, which have ramifications on the price of money for the real economy. Right now, investors are also clamouring to know more about these standards, and if they are confused, they will demand a higher return on their investment from bank securities – or go elsewhere.  

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