The introduction of International Financial Reporting Standard 9 ("IFRS9"), which requires banks to make credit loss provisioning, is expected to reduce banks' capital ratios significantly, as well as their capacity to lend, consultants said.
Concerns have been raised in the past about making provisioning too late under the existing accounting standard, International Accounting Standard 39. Under IAS 39, banks can only make provisions when a loss occurs. The new expected credit loss ("ECL") model under IFRS9, however, is more forward-looking and requires banks to make provisions for expected losses for any loans they make to cover losses that have already been incurred and those expected in the future.
IFRS9 will Reduce Banks' Capital and Ability to Lend
The introduction of IFRS9 will increase the amount of provisions, and regulators are concerned the provisions will in turn reduce banks' capital and their ability to lend, thereby affecting public confidence, said Simon Topping, head of regulatory practice at KPMG China.
"IFRS9 could affect banks' ability to lend because of the link between the amount of capital banks have and the amount they can lend," he said.
The biggest uncertainty lies in the amount of provisions which banks must provide, which will vary from country to country, said Keith Pogson, senior partner, Asia Pacific financial services at EY in Hong Kong.
"The finite increase in the amount of provisions could be 30 percent to 40 percent between the incurred loss model and the ECL model," he said.
The Basel Committee on Banking Supervision ("BCBS") has examined this in two recent consultation papers: one looks at how the capital aspect of the provision should be managed, while the other focuses on how the new accounting standard IFRS9 should be gradually phased in over a period of three to five years. BCBS has proposed to introduce IFRS9 on 1 January 2018.
IFRS9 will Reduce Tier 1 Capital
More importantly, BCBS and the industry are concerned about how IFRS9 will affect Tier 1 capital, a focus for most banks under Basel III. Topping said total capital would not be affected too much by IFRS9 but Tier 1 capital would be.
"Under Basel III, the effort was to increase Tier 1 capital, but introducing IFRS9 will reduce Tier 1 capital. Bringing in IFRS9 will potentially increase quite a lot of provisioning because it is based on expected loss which is deducted from Tier 1 capital, and as a result, Tier 1 capital will go down," he said.
The complication does not stop there, however. While provisioning is deducted from Tier 1 capital, it is added back to Tier 2 capital, according to Topping. Capital is intended to cover any future losses in the business, whereas provisioning is an amount earmarked to support future credit loss, he said.
"When part of the reserve is earmarked to support any specific risk it is counted as Tier 2 rather than Tier 1 capital. Because that amount is set aside, any amount of capital set aside for a specific purpose is no longer counted as Tier 1 capital, which is a higher quality capital," he said.
Provisioning which can be Added to Capital is Limited
The issue is further complicated by the fact the amount of provisioning which can be added to Tier 2 capital is limited. Banks which use the standardised approach to credit risk are only allowed to add provisioning of up to 1.25 percent of their risk-weighted assets to Tier 2 capital. Total capital would not change because the percentage is limited to 1.25 percent, Topping said.
"Up until the position is reached, all the provisioning can be added to Tier 2 which will go up, and the total capital will be the same. But that will not happen if the provisioning exceeds 1.25 percent. Not all the reduction in Tier 1 will be able to get added back to Tier 2 and so the overall capital will be affected," he said.
Banks using the internal risk-based model approach to credit risk face similar limitations; they are allowed to add provisioning of up to 0.6 percent of risk-weighted assets.
"The technical issue here is that not only will Tier 1 capital fall, total capital will also fall because of the cap at 1.25 percent [for banks using standardised approach] and 0.6 percent [for banks using IRB approach]," Topping said.
Another complication is the concept of provisions. Under IAS39, there are two types of provisions: general and specific. As there is no such distinction under IFRS9, it is unclear at this stage whether all the provisions under Tier 1 can be added back into Tier 2 capital. Banks using the internal risk-based approach also made no distinction between general and specific provisions.
Three Approaches to Phase in IFRS9
Given the potential complications and concerns about the impact on banks' ability to lend, BCBS is therefore considering the introduction of IFRS9 through a phased approach to spread the reduction in Tier 1 capital over several years, Topping said.
Banks have, however, questioned the need for more capital when it is the accounting methodology that has changed. BCBS has therefore suggested three approaches to phasing in the new rules over a period of three to five years.
The key regulatory question, Pogson said, lies in how to smooth in the differences arising from the change in methodology over say a three to five-year horizon, which is then up to the individual countries to decide. The three approaches proposed by BCBS are somewhat similar, he said.
The first approach, known as the straight line approach, suggests that banks take a certain finite number for the provisions and spread them out over a period of three to five years. The second approach provides provisioning as a percentage based on risk-weighted assets.
"In the second approach, say your provision goes from 1 percent to 1.4 percent of risk-weighted assets and so you are going to smooth in on a percentage basis rather than looking at finite amount of provisions. You look at the provision against the book. The change in percentage will stay the same over the period but the underlying book may change. The second approach is more dynamic and more complicated," Pogson said.
The third approach provides a more technical answer, according to Pogson. Under IFRS9,there is a three-stage model relating to non-performing loans. The first stage is when a loan is written and there is a small expectation on credit loss, and the second stage is when something has changed for the worse with the loan.
"The first two stages are really considered as the calculation of the expected loss. The third stage is when the loan becomes non-performing, which effectively constitutes an incurred loss. Under the third approach, you assess the first two stages and you work out the difference and spread it out over the three to five-year period," he said.
Challenges to National Regulators
The challenge is most national regulators are still trying to figure out the consequences IFRS9 will bring, which, Pogson said, would be a difficult decision-making process. The good news is there is finally a rule that makes sense, he said.
Asian regulators have yet to show any major concern about the imminent introduction of IFRS9, largely because the capital impact of the new accounting standard on banks in major financial markets such as Australia, Hong Kong, Japan and Singapore is not expected to be huge, Pogson said. But the capital impact of IFRS9 on banks in emerging markets such as China and India may be larger.
"That's because generally the level of portfolio credit quality is relatively strong and hence provisions are quite low at banks in developed Asian markets at this point in time. For instance, the mortgage portfolio in Hong Kong is generally in good shape and there is relatively low loan loss, and so changing the accounting methodology from one to another does not have a huge capital impact," he said.
Investors and analysts will find it challenging to ascertain the capital strength banks have when IFRS9 takes effect, Topping said.