Consistent with statements made in the “Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience” (7 April 2008) (FSF Report – April 2008), and as described more fully in a follow up to that report issued on 10 October 2008 (FSF Report – October 2008), the Financial Stability Forum (FSF) has set in train an examination of the forces that contribute to procyclicality in the financial system and possible mitigating options. This work centers on four areas: (i) the Basel II capital accord; (ii) loan loss provisioning; (iii) compensation arrangements; and (iv) valuation and leverage.
As part of that effort, the FSF Working Group on Provisioning (WG on Provisioning) is tasked with assessing the contribution of current loan loss provisioning practices to procyclicality, and whether changes in existing loan loss provisioning accounting standards could reduce procyclicality. Also, from a longer term perspective, the WG on Provisioning will consider whether changes in accounting standards could reduce procyclicality (e.g., by recognizing changes in loan loss provisioning earlier in the credit cycle) while still meeting the needs of investors for transparency in order to understand changes in credit trends.
The WG on Provisioning and its technical team met on three occasions since December 2008 to discuss the substantive issues that comprise its mandate. In addition, the working group convened an outreach session with groups representing investors, auditors, and financial institutions. At these meetings, the WG on Provisioning received input and reactions on various questions and possible alternatives to address procyclicality. Membership on the WG on Provisioning is comprised of an internationally-diverse group of technical experts representing national authorities and international bodies representing prudential supervisors, securities regulators, accounting standard setters, auditors, regulators, central bankers and international financial institutions.
Provisioning for loan losses refers to the accounting mechanism used in the recognition of credit losses and is a critical issue to effective financial reporting and separately to prudential supervision. Provisions for loan losses reduce an institution’s reported net income in the period in which the provision is recognized and decreases the carrying value of the loans held by the institution. The basic principles provided in generally accepted accounting principles in the United States (US GAAP) as issued by the Financial Accounting Standards Board (FASB) for recognizing loan loss provisions have been formally in place since 1975, and, after enhancement in 1993, have remained relatively unchanged. The basic principles provided in International Financial Reporting Standards (IFRS) as issued by the International Accounting Standards Board (IASB) for recognizing loan loss provisions are very similar to those provided in US GAAP and the principles have been in place since the IASB revised its standards in 2003. Many financial institutions in Europe and other parts of the world began to report using IFRS in 2005.
Under both US GAAP and IFRS, the accounting model for recognizing credit losses is commonly referred to as an “incurred loss model” because the timing and measurement of losses is based on estimating losses that have been incurred as of the balance sheet date.
Provisions for loan losses should cover estimated loan losses that have been identified for individual loans, as well as estimated losses for loans in a company’s portfolio that have likely been incurred, but have not yet been individually identified. Given the subjective nature of estimates of loan losses that have not yet been individually identified, provisioning for loan losses necessarily requires judgment. For a given loan portfolio, there will likely be a range of loan loss estimates that are considered reasonable.
As described more fully in Appendix A, current provisioning accounting guidance requires that loan loss estimates incorporate all observable data on losses. This observable data may include both specific and general sources of evidence, such as a specific borrower experiencing financial difficulty or changes in general economic conditions that are likely to affect default rates. Current provisioning requirements limit provisioning to losses that are considered probable. In addition, the current accounting standards do not permit credit losses based on events that are expected to occur in the future to be included in provisions until the event or events that are probable to result in a loss have occurred (e.g., borrower loss of employment, decrease in collateral values). Continue reading