R egulation D e al ing with L oan L oss P rovisioning Presentation for the seminar CREDIT RISK MANAGEMENT AND REGULATORY PROVISIONING IN AN IFRS ENVIRONMENT ID: 461151
Download Presentation The PPT/PDF document "Compatibility of IFRS and" is the property of its rightful owner. Permission is granted to download and print the materials on this web site for personal, non-commercial use only, and to display it on your personal computer provided you do not modify the materials and that you retain all copyright notices contained in the materials. By downloading content from our website, you accept the terms of this agreement.
Slide1
Compatibility of IFRS and Regulation Dealing with Loan Loss Provisioning
Presentation for the seminar: CREDIT RISK MANAGEMENT AND REGULATORY PROVISIONING IN AN IFRS ENVIRONMENT
Vienna
,
October
21, 2014Slide2
Regulatory Framework for NPL Recognition and Provisioning – the Case of CroatiaSlide3
Run-up to Crisisthe Croatian National Bank traditionally applies a wide array of prudential regulation established through subordinate legislation (“decisions”)signed by the governor; the adherence of banks to the decisions is supervised by the banking supervision departmentsprudential regulation is created based on experience with the 1998-2000
crisis, when a significant part of the banking system collapsed or was bailed out through massive and extremely costly government supportthat situation created public and political awareness about risks associated with banking operations
in the 2000-2006
period
, due to positive market development
s
and consistent regulation, bank portfolios were mopped up from
the
crisis impact: NPLs decreased below 5%
,
and they were
provisioned for
by 60%
the
effects of prudential regulation improved
due to
active application of macro-prudential measures Slide4
Regulatory Framework the Accounting Act – introduces IFRS as standard accounting practice in Croatia (especially for banks)the Credit Institutions Act & the Act on the Croatian National Bank – give supervisory and regulatory powers to the CNB the Decision on the Classification of Placements and Off Balance Sheet Liabilities
– creates operational framework for supervision and accounting of credit riskSlide5
Basic Accounting & Prudential Framework before 2013NPL definition:non-collateralised: 90 days past duecollateralised: loans which will not be fully recovered, depending on the estimation of cash flows, but at the latest two years after taking legal actions by activating collateral
provisioning based on IAS 39 modified by:compulsory classification as NPL (with at least minimal provisions) 90 days past due if no legal action was taken30% compulsory
provisioning
two years after legal action
was taken to collect the loan
for non-collateralised loans prescribed provisioning depending on past-due time buckets:
90 – 180 days past due, up to 30%
180 – 270 days past due, 30% up to 70%
270 – 365 days past due, 70% up to 100%
more than 365 days past due, 100%
the
interest on NPLs
is recognised only if
collected
(not based on accrual)Slide6
Dynamics of NPL and Provision Coverage 2005-2014decrease of coverage is the consequence of inflow of fresh, low provisioned NPLs, but also of sometimes quite imaginative
and very brave collection planson-site examination was used as an auxiliary tool with some success; the majority of coverage increase in 2011 and 2012 was its contribution; active resistance of banks to risk recognition created extremely high workload for both staff and management of the CNB
the l
ack of standard NPL definition increased the problem, as banks claimed that our NPL definition is stricter than in other jurisdictions, so coverage rates are not comparable
From 2007
until 2010
NPL
coverage
radically
decreased
in spite of stable regulation.
As coverage stagnated subsequently, in 2012 it became obvious that prudential regulation isn’t getting proper traction. Slide7
Comparative Dynamics ISource: IMF, FSI TablesSlide8
Comparative Dynamics IISource: IMF, FSI TablesSlide9
Issues Notedmajor weaknesses recognized in accounting practices were:30% provisioning was required two years after taking legal action to collect the loan; to avoid it, banks simply didn’t take legal action (initiate foreclosure)after 30% provisioning no additional provisioning was compulsory in spite of process duration and complexity“
running two year gap” – cash flow from collateral was always expected two years from now; typical IAS 39 based evaluation was based on the best case scenario; in supervised banks all estimates of time and sale price of real estate collateral proved drastically wrong
in evaluation,
the
real estate value is average of
the following
three
components
: market value, replacement value and present value
;
m
arket value was based on the last known similar transaction (frequently before 2008)discontinued projects were evaluated as completed auditors confirmed everything, providing that it could technically be presented under IFRS frameworkfindings of on-site examinations and shareholders' reactions to these findings made obvious that the management and the owners jointly pursue a strategy of optimistic valuation and that auditors are ready to support itSlide10
Change of Regulation in 2013 amendments to the Decision on the classification of placements were adoptedthose amendments made the following changes:compulsory provisioning was regulated in detail:compulsory 10% provisioning 90 days past due (delinquency), if no collateral was activated
compulsory 20% provisioning one year after delinquency, if adequate collateral was not activatedcompulsory 30% provisioning two years after delinquency, regardless of legal action taken to activate a collateral;after accounting for 30%, each 6 months an additional 5%
compulsory provisioning
minimum of 1% provisions was established for NPLs
regulation of restructured loans (how to treat them after restructuring, criteria for their rehabilitation into performing loans)
compulsory minimum haircuts and collection periods
were introduced for real estate and movable property
consecutive compulsory provisions (10%, 20%, 30%) were aimed
at
motivat
ing
banks to timely start foreclosure, while the additional 5% provisioning was a kind of “lump sum” correction for all other noticed aberrations from best practice
; others are meant to adjust NPL & forbearance definition to the new definition approved by EBA BoS (ITS on supervisory reporting regarding forbearance and non-performing exposures)Slide11
Impact of Regulationthe introduction of the Decision amendments was designed to have full accounting impact by end-2013the consequences were obvious:the cost of provisioning increased from 4 to 6 billion kuna – roughly for 0,5% of total assets, reaching 89% of operational results
the coverage of NPLs by value adjustments increased from 42,6% to 46,2%but:the banking system remained overall
profitable
workout
operations and sale of NPLs
intensified
banks’ overall and operational results in 1H2014 improved significantly compared with
the
same period last year in spite of stricter regulationSlide12
International Financial Reporting Standards (IFRS) and Prudential RegulationSlide13
IFRSIFRS offer standardised reporting framework they facilitate transparency of markets and comparability of different investment opportunitiesthe optimal allocation of capital depends on proper application of IFRS
The valuation of certain asset classes under IFRS is sensitive to assumptions appliedSlide14
When Arbitrary decisions influence IFRS reports?core portfolios, such as performing loans and all positions created through arms length transactions are evaluated based on “pure” IFRSprudential regulation interferes only with “marginal” high risk portfolios: NPL & problem loans, litigations, regulatory breaches and deviations from good corporate governance
the valuation of such positions is based on subjective judgment about future outcome. the implementation of prudential standards limits subjective judgment, increasing comparability of banks’ accountsprudential reports will materially deviate from IFRS reporting only if the bank has a very risky business profile
.
Reporting is the
responsibility
of the
management
. If they find
the
regulatory requirements misleading, they
should adjust
the regulatory reporting through a “
statement of differences” for tax and shareholders reporting purposes. Slide15
Preconditions for IFRS Effectivenessthe precondition for accurate accounting is an active supervision of management reporting by shareholders motivated to recognize the real value of their assetsin banking, regulation could strongly
influence the rational behavior of shareholders, making them more relaxed toward overvaluation of bank’s assetsIn certain circumstances rational shareholders would
motivate
management and auditors
to apply
optimistic assumptions
in valuation of bank’s assets. If so, IFRS lo
o
se its major purpose – providing comparable accountsSlide16
Shareholders’ Benefits from Optimistic Valuationif an institution is close to a regulatory minimum, rational shareholders would attempt to fulfill
the regulatory requirement with “ghost capital”. the “ghost capital” created through optimistic valuation would improve regulatory compliance and, due to avoidance of dilution, (modeled in appendix), increase the expected RoE
; a
dditionally, it would create immediate material benefits for managers
without regulatory interference, such a
strategy is financially superior
to prudent accounting
in
extreme cases
such motivation did create “
moral hazard
”
without effective regulatory checks an obvious temptation does exist; to increase the robustness of the system, the regulation should establish the minimum required level of prudenceIAS 39 offers the possibility to increase the capital buffer through
an
optimistic valuation of NPL/problem loans. Slide17
Protecting Public Interestprudent bank accounting protects the key public interest because:banking is a critical infrastructure of the economy and its robustness depends on proper
accountingin several countries banks’ managers recently acted as “fiscal agents”, effectively ruining or at least hampering the fiscal positionproperly acting supervisors/regulators decrease fiscal risks and improve the
financial stability
Historical
l
y,
financial impact
of too
optimistic
banking
accounting
is obvious and significant, most likely
exceeding any potential adverse impact of prudential regulation Slide18
Conclusiondoes prudential regulation distort financial reporting to the level hampering transparency of financial markets?we argue that, banks’ management, shareholders and auditors have common incentive to use “income smoothing”, achieved through optimistic discretion within IFRS framework; incentives strengthen if bank approaches the regulatory limits
by limiting such behavior banking regulation improves comparability of accountsbanks’management has tools to rectify the requirements of prudential regulation in reporting to shareholdersprudential regulation is public and transparent, so it can’t distort public information; anyway, if distortion appears, its potential adverse effect is only speculative and obviously smaller than potential effects of improper banking accounting
IFRS shouldn’t be a straightjacket for banking regulation.
Their
subjective elements open a possibility for the banks to overestimate capital, potentialy creating a significant fiscal impact! Slide19
Thank you for your attention!Slide20
AppendixSlide21
Comparative NPV – Retained EarningsYear 0
Bank has regulatory capital 100 and annual AT profit 10.
Bank has 100 shares.
Discounting factor for calculation of NPV is 5%
All profit goes to retained earnings.
prudent accounting
optimistic accounting
profit AT
Equity
profit
per
share
NPV
profit AT
Equity
profit per share
NPV
0
-50,00
100,00
-0,5000
0
10,00
110,00
0,1000
1
11,00
111,00
0,0550
1
10,00
120,00
0,1000
2
11,22
122,22
0,0561
2
10,20
130,20
0,1020
3
11,44
133,66
0,0572
3
10,40
140,60
0,1040
4
11,67
145,34
0,0584
4
10,61
151,22
0,1061
5
11,91
157,24
0,0595
5
-50,00
101,22
-0,5000
Stock price
1,1907
0,9329
Stock price
2,1620
1,6940
Scenario:
Scenario:
In year 0 due to increased risk
No recognized risks in year 0
recognized one off provisioning
Loss recognized in year 5 and covered from reserves
cost 60 creating loss 50.
Loss is covered from existent
equity.
Capital shortage was covered
through public issuance of shares.
Fresh capital increased profit for 1
Stock price in year 6 is 20 *PPS (profit per share adjusted for one-off items)Slide22
Comparative NPV – Dividend PayoutYear 0
Bank has regulatory capital 100 and annual AT profit 10.
Bank has 100 shares.
Discounting factor for calculation of NPV is 5%
All profit goes to dividend.
prudent accounting
optimistic accounting
profit AT
Equity
profit per share
dividend
NPV
profit AT
Equity
profit per share
dividend
NPV
0
-50,00
100,00
-0,5000
0,0000
0,0000
0
10,00
100,00
0,1000
0,1000
0,1000
1
11,00
100,00
0,0550
0,5000
0,0524
1
10,00
100,00
0,1000
0,1000
0,0952
2
11,00
100,00
0,0550
0,5000
0,0499
2
10,00
100,00
0,0980
0,1000
0,0889
3
11,00
100,00
0,0550
0,5000
0,0475
3
10,00
100,00
0,0980
0,1000
0,0847
4
11,00
100,00
0,0550
0,5000
0,0452
4
10,00
100,00
0,0980
0,1000
0,0806
5
11,00
100,00
0,0550
0,5000
0,0431
5
-50,00
100,00
-0,5000
-0,5000
-0,3918
0,2381
0,0576
Stock price
1,1000
0,8619
Stock price
2,0000
1,5671
NPV CF
1,1000
NPV CF
1,6247
Scenario:
Scenario:
In year 0 due to increased risk
No recognized risks in year 0
recognized one off provisioning
Loss recognized in year 5 and covered by shareholders
cost 60 creating loss 50.
Loss is covered from existent
equity.
Capital shortage was covered
through public issuance of shares.
Fresh capital increased profit for 1
Stock price in year 6 is 20 *PPSSlide23
BibliographyVincent Bouvatier, Laetitia Lepetity
, Frank Strobelz “Bank income smoothing, ownership concentration and the regulatory environment”; November 19, 2013
Laeven
, L., Levine, R., “Bank governance, regulation and risk taking”., Journal of Financial Economics 93, 259.275. 2009.
Morgan, D. “Rating banks: risk and uncertainty in an opaque industry.”, The American Economic Review 92, 874.888. ., 2002
Chen, Linda H., Income Smoothing, Information Uncertainty, Stock Returns, and Cost of Equity (October 1, 2012). Review of Pacific Basin Financial Markets and Policies (RPBFMP),
Chen, Tai-Yuan and Chin, Chen-lung and Wang,
Shiheng
and Yao, Chun, The Effect of Mandatory IFRS Adoption on Bank Loan Contracting (January 8, 2013). Available at SSRN:
http://ssrn.com/abstract=2159001
Calomiris
, Charles
W , Haber, Stephen H.”Fragile by Design”, Princeton University Press, (2014),ISBN 978-0-691-15524-1