Provisioning policies for non-performing loans: How to best ensure a “clean balance sheet”?

Grinnanailís 06-11-2017

The paper explains the accounting mechanics regarding loan loss provisions (LLP) and introduces the three most important models for loan loss provisioning: the incurred loss model (ILM), the expected credit loss model (ECL) and the counter-cyclical buffer model (CBM). The paper investigates the preferred method to calculate loan loss provisions that from the viewpoint of financial accounting needs (information needs of financial statement readers) and prudential regulation (micro and macro prudential supervision). Based on economic reasoning the expected loss model is shown to be the preferred model for both purposes. The new IFRS 9 accounting standard is a mixture between the current incurred loss model and the expected credit risk model while the American standard setter FASB has introduced a pure version of the expected credit loss concept in the United States. The paper urges a convergence of IFRS 9 towards the FASB model. The paper investigates the key differences between the LLP concepts as they are currently used and applied in accounting and prudential supervision. It argues that both financial accounting and banking supervision should be based on a harmonized concept for LLP calculation in the future. The proposed transition rules of the EU commission should be adapted in order to prevent unwarranted increases of regulatory capital.