Loss provisions
This is a high level review of loan provisioning – the recognition of potential losses is prescibed in both the Basel accord and IAS 39 (International Accounting Standards).
Note. IFRS 9 (Intl Financal Reporting Standards) is soon to replace IAS 39 and uses a single approach to determine whether a financial asset is measured at “amortized cost” or “fair value” and requires a single impairment method to be used.
Loan loss provisions are funds set aside to cover bank’s losses and ensure that both income and capital are correctly reported in the bank’s books.
In small $ loan portfolios with similar risk characteristics, loan loss provisions are estimated by using historical loss information as the starting point, which can then be tweaked dependant of external factors – such as the unemployment rate movements – these provisions are referred to as “collective provisions”
For large $ loans, a bank makes individual assessment of the likely loss, which includes an evaluation of the borrowers financial position, any guarantees and their likley value and the likely realisable value of security – these provisions are referred to as “individual provisions”
Provisions are then accounted for based upon the bank’s estimate of loss on what has occured and what is likely to occur.
When provisions are “raised” they are financially treated as an expense to the bank – which ultimately impact on shareholders equity/capital. The asset (loan portfolio) is subsequently recorded at its net value.
Technically – IAS 39 prescribes the definition and treatment of provisions as follows:
A financial asset or group of assets is impaired, and impairment losses are recognised, only if there is objective evidence as a result of one or more events that occurred after the initial recognition of the asset. An entity is required to assess at each balance sheet date whether there is any objective evidence of impairment. If any such evidence exists, the entity is required to do a detailed impairment calculation to determine whether an impairment loss should be recognised. [IAS 39.58] The amount of the loss is measured as the difference between the asset’s carrying amount and the present value of estimated cash flows discounted at the financial asset’s original effective interest rate. [IAS 39.63]
Assets that are individually assessed and for which no impairment exists are grouped with financial assets with similar credit risk statistics and collectively assessed for impairment. [IAS 39.64]
If, in a subsequent period, the amount of the impairment loss relating to a financial asset carried at amortised cost or a debt instrument carried as available-for-sale decreases due to an event occurring after the impairment was originally recognised, the previously recognised impairment loss is reversed through profit or loss. Impairments relating to investments in available-for-sale equity instruments are not reversed through profit or loss. [IAS 39.65]
The Basel committee recently provided their view of the core principles relating to loss provisioning for the purposes of revising IAS 39. The revision of IAS 39 was in response to the credit crisis and the subsequent recommendation by the G20 leaders in April 2009 to improve standards on valuation and provisioning and achieve a single set of high-quality global accounting standards. The Basel committee principles are:
1. Loan loss provisioning should be robust and based on sound methodologies that reflect expected credit losses in the banks’ existing loan portfolio over the life of the portfolio. The accounting model for provisioning should allow early identification and recognition of losses by incorporating a broader range of available credit information than presently included in the incurred loss model and should result in an earlier identification of credit losses.
2. The provisioning approach should allow for the exercise of professional judgement while using leading economic indicators, changes in underwriting standards and collection practices, and other relevant information when estimating provisions or allowances. Judgement related to these provisions should be well evidenced.
3. The new standard should allow for provisions for groups of loans with similar risk characteristics.
4. The new standard should utilise approaches that draw from relevant information in banks’ internal risk management and capital adequacy systems when possible (eg approaches that build upon or are otherwise consistent with loss estimation processes related to bank internal credit grades may be useful).
5. The approach should encourage provisioning to address credit losses across the entire range of bank internal credit grades for loan portfolios.
6. The new standard should apply the same impairment approach to all financial assets measured using amortised cost.
I will be keeping a close eye on ozrisks blog who have been analysing the revision of IAS39/IFRS 9
Here’s NZ IAS 39 definition and treatment for assets carried at amortised cost (loan books)
If there is objective evidence that an impairment loss on loans and receivables or held-to-maturity investments carried at amortised cost has been incurred, the amount of the loss is measured as the difference between the asset’s carrying amount and the present value of estimated future cash flows (excluding future credit losses that have not been incurred) discounted at the financial asset’s original effective interest rate (ie the effective interest rate computed at initial recognition). The carrying amount of the asset shall be reduced either directly or through use of an allowance account. The amount of the loss shall be recognised in profit or loss.
An entity first assesses whether objective evidence of impairment exists individually for financial assets that are individually significant, and individually or collectively for financial assets that are not individually significant (see paragraph 59). If an entity determines that no objective evidence of impairment exists for an individually assessed financial asset, whether significant or not, it includes the asset in a group of financial assets with similar credit risk characteristics and collectively assesses them for impairment. Assets that are individually assessed for impairment and for which an impairment loss is or continues to be recognised are not included in a collective assessment of impairment.
If, in a subsequent period, the amount of the impairment loss decreases and the decrease can be related objectively to an event occurring after the impairment was recognised (such as an improvement in the debtor’s credit rating), the previously recognised impairment loss shall be reversed either directly or by adjusting an allowance account. The reversal shall not result in a carrying amount of the financial asset that exceeds what the amortised cost would have been had the impairment not been recognised at the date the impairment is reversed. The amount of the reversal shall be recognised in profit or loss.
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So, between balance dates, reporting entities have no obligation to provision for bad loans? I am wondering if South Canterbury Finance is within the law to refrain from provisioning for bad loans, apparently as a way to avoid breaching capital adequacy requirements in the trust deed.
@David Hillary – Im not sure about Sth Cant Finance – but the Basel accord requires Banks …. “To ensure that impairment in loans is identified in a timely manner, loans should be
reviewed for impairment in credit quality on a regular basis … Loans should
be reviewed for impairment between reporting dates whenever substantive information exists
that indicates a significant deterioration has occurred in the credit quality in a material part of
the loan portfolio.
Well I’ve spoken to someone in the know about SCF who has explained why there weren’t any provisions for 30 June to 20 Oct. The story is that the auditing process was looking at the post balance date data up to when the audit was signed off on 30 Sept, and so the 30 June figure incorporated information post balance date, so that the next regular internal provisioning date is probably 31 Oct.