The concept that bankers know when they are going to make a loss – which forms part of the IFRS9 rules launched in in 2018 – is fundamentally flawed.

If bankers knew they were going to make losses on a loan they wouldn’t make it. This is the big conceptual flaw in the theory of provisioning for expected losses which will take effect from January 2018 under International Financial Reporting Standards, or IFRS9 as it will more commonly be known. 

Probably the mistake is as much in the language as the accounting. What we are really talking about here is provisions for unexpected losses and it is true that in the financial crisis, under a system of incurred losses provisions were too low. Or just simply that capital was too low, since the idea of a capital buffer is to protect the bank against unexpected losses and the logic of risk-weighting assets is to ensure that banks hold appropriate levels of capital. 

Fortunately, the International Accounting Standards Board has shown some restraint in opting for a new model based on banks recognising a 12-month expected credit loss on the majority of loans only moving to a lifetime expected loss when there has been significant credit deterioration. 

Even so, the general consensus is that the new rules will lead to a 35% increase in the level of provisioning. The worry is that banks already constrained in their activities by holding much larger amounts of capital will be restricted even further, especially in areas such as SME lending, which are vital for growth. 

Going down the expected losses road – even the current soft version – involves accounting based on difficult-to-make judgements, rather than a more objective assessment of actual losses. While it is true that accounting can often be more of an art than a science, putting a number on expected losses when a loan is made is more fantasy than reality. 

This means that analysts will find it difficult to compare how banks have reached their conclusions despite the requirement that banks explain their inputs, assumptions and techniques. There will also be increased volatility in the profit and loss as assessments are changed. 

Is this really the best way forward? What banks need are solid capital buffers and portfolios with diverse assets that are perceived as more or less risky and charged accordingly. Broad guidelines in the form of capital ratios are clearly needed to preserve the system but micromanaging every loan decision that is made in a bank may have negative outcomes for both lending and economic growth.

Brian Caplen is the editor of The Banker.

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