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Written by Prashant Dimri, Consultant.
Introduction
This article summarizes an ECB working paper which aims to talk about how the IFRS9 framework has impacted provisioning behavior in different banks, especially in the face of macro-economic shocks such as the COVID-19 pandemic and an energy price shock.
The International Financial Reporting Standard 9 (IFRS9) brought about a significant change in how banks calculate provisions for credit losses. Prior to IFRS9, the Incurred Loss (IL) model was used, which was essentially a backward-looking approach, triggering provisions only after default events had occurred. This model raised concerns about pro-cyclicality in the banking system, where provisions surged during economic downturns, leading to capital constraints and reduced lending capacity. To address these issues, the Expected Credit Loss (ECL) model, as embodied by IFRS9, was introduced globally. In the IFRS9 model, loans are categorized into three stages: Stage 1 (Performing), Stage 2 (Under-performing), and Stage 3 (Non-performing).
Provisioning Dynamics Under IFRS9
Under IFRS9, the provisioning methodology is more forward-looking compared to the IL model. Provisions are expected to be higher before the occurrence of a default event and are designed to be more responsive to economic shocks. However, an interesting observation is that a significant portion of provisioning still occurs at the time of or after default events, similar to the traditional accounting approach, known as national General Accepted Accounting Principles (nGAAP). This suggests that despite the shift to a more ECL-based framework, provisioning dynamics around default events have not fundamentally changed.
One key challenge that banks face in implementing IFRS9 is the identification of Significant Increase in Credit Risk (SICR) at an early stage. As a result, a substantial number of loans continue to be classified as Stage 1, which is the performing stage. This inability to move loans to Stage 2 (under-performing) shortly before default highlights the difficulty banks encounter in recognizing early signs of credit risk. Consequently, IFRS9 has not radically altered provisioning patterns in this regard.
Another noteworthy aspect is the role of discretion in banks' accounting practices. IFRS9 provides banks with some flexibility in provisioning, allowing them to provision less, especially if they have limited capital headroom. In contrast, banks with more capital headroom tend to increase provisions ahead of default for loans using IFRS9. While this flexibility can help less-capitalized banks avoid a significant increase in provisions during economic downturns, it also reduces transparency and may lead to under-provisioning, particularly for banks that are already at a greater risk due to their capital constraints.
Procyclicality in IFRS9
One of the primary concerns with IFRS9 is the potential for excessive procyclicality. A sudden and significant deterioration in economic conditions can lead to a sharp increase in loss provisioning even before actual default events occur. This, in turn, can reduce banks' capital positions and limit their ability to extend credit, exacerbating economic downturns. To mitigate this risk, authorities have introduced ad-hoc support measures such as encouraging banks to incorporate flexibility within the IFRS9 framework, implementing loan moratoria, or providing state guarantees.
The introduction of flexibility in IFRS9 allows banks to manage provisions in a way that aligns with their capital availability. While this can help reduce procyclicality, it also comes with a trade-off, as it diminishes transparency and makes it harder to gauge the true extent of credit risk within a bank's loan portfolio. The paper emphasizes that finding the right balance between flexibility and transparency is crucial, as excessive flexibility can lead to under-provisioning, which may have systemic implications if significant losses materialize.
Exposure to Macro-Economic Shocks
The paper also examines the impact of macro-economic shocks on provisioning dynamics, particularly focusing on the energy price shock in 2022. The study uses loan data matched with an energy intensity measure constructed by the European Central Bank, which helps identify sectors heavily dependent on energy inputs, such as industrial and construction sectors.
When considering the impact of the COVID-19 pandemic, the paper finds that banks with higher capital levels tend to make more provisions. Better-capitalized banks are also more likely to move loans to Stage 2 under IFRS9. In the case of the energy price shock, provisions for IFRS9 loans increased significantly for energy-intensive sectors after the shock. Banks with more capital headroom again responded by increasing provisions more than their counterparts.
Regression Strategy
To analyze the impact of accounting standards and bank characteristics on provisioning behavior, the paper employs three types of regression tests:
Determinants of Provisioning Ratio: This analysis focuses on understanding the general drivers of provisioning behavior. It assesses changes in the provisioning ratio at the bank-firm level, with variables like accounting standard (IFRS9 vs. nGAAP), bank capitalization etc.
Provisioning Dynamics around Idiosyncratic Credit Events: By examining provisioning dynamics around individual loan-level events, it aims to identify potential cyclical implications of different accounting standards and bank practices. In other words, whether provision dynamics are generally different between loans using different accounting standards or loans issued by different banks which derive insight on cyclical implications.
Provisioning Dynamics around Macro-Economic Shocks: This analysis investigates provisioning dynamics during macro-economic shocks, such as those triggered by the COVID-19 pandemic and the outbreak of war in Ukraine. These events have broader systemic implications, and understanding their impact on provisioning is crucial.
The results of the analysis indicate that, as intended, provisions under IFRS9 are higher than those under nGAAP. During the COVID-19 pandemic, non-performing loans improved, but there was a noticeable increase in Stage 2 provisions. Banks with more capital headroom tend to make higher provisions, consistent with capital management motives. The analysis also highlights the influence of discretion on provisioning behavior.
Conclusion
In conclusion, this paper provides valuable insights into the functioning of IFRS9 under real-life economic stress, supported by loan-level data. Future research should continue to assess the impact of IFRS 9 on financial stability and the lending behavior of banks in various economic scenarios. Certain challenges persist, such as the difficulty in identifying SICR at early stages, leading to most of the provisioning occurring at the time of default. Provisioning dynamics between IFRS9 and nGAAP remain rather similar.
Furthermore, the paper emphasizes the importance of accounting flexibility in mitigating potential procyclical effects after an economic shock, particularly for less-capitalized banks. However, this flexibility comes at the cost of reduced transparency, potentially leading to under-provisioning and systemic risks if losses materialize. Future research should continue to assess the impact of these factors on financial stability and the lending behavior of banks in various economic scenarios. It is crucial to strike a balance between flexibility and transparency to maintain the resilience of the financial system while avoiding undue procyclicality.