The authorities are giving banks scope to take a softer line on forward provisioning accounting rules, in the hope of preserving capital and the economy. Nonetheless, a sharp rise in bad loans is almost inevitable.
What is happening?
Regulators are asking banks not to be overzealous when provisioning for bad loans under the IFRS 9 accounting standard that came into force in 2018. The US equivalent is the Current Expected Credit Loss (CECL) standard, coming into force in 2020.
These standards were finally brought in a decade after the 2007-09 global financial crisis at the behest of regulators, who were unsatisfied with the previous incurred loss model where banks declared loans as non-performing after the event. Many reported too many losses too late or simply tried to hide them for years.
The solution was the IFRS 9 forward-looking approach where banks, looking at economic forecasts, try to predict how many of their loans may go sour (for instance, if a recession is looming) and set aside capital for such an event. This was meant to better prepare them for a rise of non-performing loans (NPLs) that normally accompanies a downturn.
However, this first test for the standard is a particularly brutal one, namely the Covid-19 pandemic where population lockdowns to stop its spread are leading to double-digit plunges in gross domestic product at a speed of decline not even seen during the Great Depression of the 1930s.
Regulators have responded by allowing banks to relax capital buffers and were concerned that much of this capital could be diverted towards forward provisioning for losses under IFRS 9. But the authorities do not want those relaxed prudential buffers to be reabsorbed into forward provisioning. Also, if the provisioning is too harsh, they fear it could lead to capital being choked off from the economy and swathes of business – even entire industries – being pushed into bankruptcy.
The general theme of the guidance is therefore to keep supporting viable businesses – for instance, those in the leisure sector that were financially sound before Covid-19.
The authorities also want banks, when doing this forward provisioning, to take into account massive fiscal and monetary stimulus measures, along with initiatives that range from loan guarantees and loan payment holidays to some governments paying the wages of furloughed staff. All these measures are unprecedented in scale and reach.
In the case of the US, the authorities are allowing banks to delay CECL for up to two years and phase them in over three years, to mitigate some of the estimated cumulative regulatory capital effects of the rules.
Why is it happening?
Governments want to preserve as much of the ‘dormant’ economy as possible so it can return to business as usual. Bankruptcies are messy and disruptive – potentially damaging supply chains, hindering supply and demand and leading to joblessness and a surge in NPLs.
Many banks start provisioning for loans as potentially going bad if payments are more than 30 days late, because research shows these loans will typically be impaired in 12 months’ time. The authorities want to avoid those accounting measures being triggered by reminding banks of the various government guarantees and mandated payment holidays being rolled out.
In other words, when looking over a multi-year period, many of those loans should once again be performing, thanks to the combination of business support measures and the hoped-for rebound in the economy from the monetary and fiscal measures once the lockdowns end.
What do the bankers say?
Bankers are concerned about the economic fallout from the pandemic. Early indications suggest some are making substantial provisions for bad loans, with Italy’s largest bank, UniCredit, announcing provisioning of €900m for loan losses for the first quarter of 2020, compared with €468m for the same period in 2019.
Indeed, one analyst advised banks to throw the “kitchen sink” at their first quarter provisions as they are a non-cash item, and if fewer loans go bad than estimated, they can be written back.
Will it provide the incentives?
IFRS 9 is a principles-based standard and offers considerable flexibility in provisioning for bad loans, provided the estimates make sense. In such an unprecedented environment, it is challenging to produce reliable forecasts, making credible provisioning difficult. However, the message from the authorities is for banks to be patient with ‘viable’ businesses, so they will be expected to do so.
But despite massive state support, millions of jobs are being lost and many companies are failing so a big increase in bad loans appears unavoidable. Indeed, the economic recovery probably will not be V-shaped but more bath shaped – meaning many businesses will never recover.
