Incurred Loss Model Research Articles

The Effect of the Current Expected Credit Loss Approach on Banks’ Lending during Stress Periods: Evidence from the COVID-19 Recession

ABSTRACT In the wake of the financial crisis, policymakers expressed the concern that the incurred loss model delays loan loss recognition to economic stress periods and thereby exacerbates banks’ lending contraction during these periods. Addressing this concern, the FASB issued Accounting Standards Update 2016-13, which requires large public banks to accrue for loan losses using the current expected credit loss (CECL) approach starting in January 2020. We hypothesize and find that banks that adopted CECL prior to the COVID-19 pandemic increased loan loss provisions and reduced loan growth during the accompanying recession more than other banks. The lending contraction is stronger for adopting banks with low regulatory capital and low loan impairment and is primarily driven by commercial loans. Lastly, we find that counties in which CECL-adopting banks have higher market share experience larger increases in unemployment rates during the recession and slower subsequent recoveries. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: E32; G21; G28; M41; M48.

The impact of IFRS 9 on the cyclicality of loan loss provisions

AbstractThrough their procyclical behavior, loan loss provisions have been determined as one of the factors that contribute to financial instability during a crisis. IFRS 9 was introduced in 2018 with an expected credit loss model replacing the incurred loss model of IAS 39 to mitigate the effect in the future. Our study aims to analyze loan loss provisions of major banks in the Eurozone to determine for the first time if the implementation of IFRS 9, as intended by regulators, has a dampening effect on procyclicality, especially during the stressed situation under COVID‐19. We analyze 51 banks from 12 countries of the European Monetary Union using 2856 firm‐year observations. While no robust evidence of less procyclicality can be found after the implementation of IFRS 9 until the pandemic, we find evidence that loan loss provisions moved countercyclical during 2020, indicating an alleviating effect at the beginning of the exogenous shock.

CECL: Timely Loan Loss Provisioning and Bank Regulation

ABSTRACTWe investigate how provisioning models interact with bank regulation to affect banks' risk‐taking behavior. We study an accuracy versus timeliness trade‐off between an incurred loss model (IL) and an expected loss model (EL) such as current expected credit loss model or International Financial Reporting Standards 9. Relative to IL, even though EL improves efficiency by prompting earlier corrective action in bad times, it induces banks to originate either safer or riskier loans. Trading off ex post benefits versus ex ante real effects, we show that more timely information under EL enhances efficiency either when banks are insufficiently capitalized or when regulatory intervention is likely to be effective. Conversely, when banks are moderately capitalized and regulatory intervention is sufficiently costly, switching to EL impairs efficiency. From a policy perspective, our analysis highlights the roles that regulatory capital and the effectiveness of regulatory intervention play in determining the economic consequences of provisioning models. EL spurs credit supply and improves financial stability in economies where intervening in banks' operations is relatively frictionless and/or regulators can tailor regulatory capital to incorporate information about credit losses.

Pro-Cyclicality of Provisions for Loan Losses

The crux of bank accounting is how to measure and disclose ex ante credit risk, as loan yields and cost of funds are determined by managerial effectiveness and the financial market. This paper examines how the practice of setting up provisions for loan losses by bank managers had changed to preserve regulatory capitals around the 2008 financial crisis. This paper examines the empirical relationship between ex ante credit loss, which is proxied by loan losses provisions, and realized credit loss, which is measured by net charge-off. The empirical relations are examined before, during, and after the 2008 financial crisis to find the patterns of prediction errors of the incurred loss model. This paper obtains evidence that the empirical relation between non-performing assets and provisions for loan losses weakened at the time of a financial crisis. The relations of net charge-offs and allowance for loan losses on provisions for loan losses amplified during a financial crisis by accounting design. After the financial crisis is over, the empirical relation between non-performing assets and provisions for loan losses does not return back to the pre-crisis relation, but to a different, new post-crisis relation. This paper obtains evidence that financially stable banks in terms of the tier 1 capital ratio, return on assets, market-to-book ratio, or dividend payout ratio tend to adjust provisions for loan losses in a larger scale in response to a financial crisis than less stable banks.

Distressed Debt Management & Lessons Learnt Through Case Management: Banking Industry in Kenya

Deteriorating and troubled assets must be subjected to enhanced risk oversight and monitoring to ensure that appropriate action is taken in a timely manner, allowing a high level of obligor turnaround success and reduced risk of loss for the Lender/Financial Institution/Bank. It’s important for a Bank to harmonize Distressed Debt Management approach, called the Watch List (WL) Framework, and details the requirements to ensure timely adherence to regulatory requirements. The impairment requirements of International Financial Reporting Standards (IFRS 9) Financial Instruments, effective as of 1 January 2018, are based on an Excepted Credit Loss (ECL) model and replace the IAS 39 Financial Instruments; Recognition and Measurement incurred loss model. IFRS 9, recognizes impairment allowances on either a 12-month or lifetime ECL basis, dependent on whether there was a significant increase in credit risk (SICR) since initial recognition (being either asset origination date or ‘base date’, whichever is most recent). The measurement of ECL reflects both a probability-weighted outcome and the time value of money, using the best available forward-looking information. There should be relevant policies that would require to be read in conjunction with relevant manuals and Accounting Standards. It’s equally important to detail the monitoring objectives for consistent management of wholesale impairment and the provisions necessary to meet regulatory requirements. It is imperative that when dealing with Distressed Debt/Assets, that attention is given to the requirements detailed under Conduct Risk and that client confidentiality is maintained. Mostly, business failure is a result of financial and/or economic distress. A firm in financial distress experiences a shortfall in cash flow needed to meet its debt obligations. Its business model does not necessarily have fundamental problems and its products are often attractive. In contrast, firms in economic distress have unsustainable business models and will not be viable without asset restructuring. In practice, many distressed firms suffer from a combination of the two. Many factors contribute to the high number of business failures. Some common failures include and are not limited to the below. Poor operating performance and high financial leverage. A firm's poor operating performance may result from many factors, such as poorly executed acquisitions, competition, overcapacity, new channels of competition within an industry (e.g., retail), commodity price shocks (e.g., energy), and cyclical industries (e.g., airlines). High financial leverage exacerbates the effect of poor operating performance on the likelihood of corporate failure. Lack of technological innovation. Technological innovation creates negative shocks to businesses that do not innovate. The arrival of a new technology often threatens the survival of firms that possess related, yet less competitive, technologies. There needs for a business to strategically position itself in the market through digital transformation in its processes, product development and operations Liquidity and funding shock. In periods of weak credit supply, some businesses are unable to roll over maturing debt because of illiquidity in credit markets. Relatively high new business formation rates in certain periods. New business formation is usually based on optimism about the future. But new businesses fail with far greater frequency than do more seasoned entities, and the failure rate can be expected to increase in the years immediately following a surge in new business activity. Deregulation of key industries. Deregulation removes the protective cover of a regulated industry (e.g., airlines, financial services, HealthCare, energy) and fosters larger numbers of entering and exiting firms. Competition is far greater in a deregulated environment. Unexpected liabilities. Businesses may fail because off-balance sheet contingent liabilities suddenly become material on-balance sheet liabilities.

Expected credit losses and managerial discretion. Current practices and future challenges

This paper examines the loan loss provisioning behaviour during the transition from IAS 39 to IFRS 9 for a sample of 403 banks in 27 countries in European Union. The objective of the study is to investigate whether during the first years of adoption of the new expected credit loss (ECL) impairment model banks are more en-couraged to smooth earnings and manage capital, compared to the previous in-curred loss (ICL) model. Results show that under ECL, banks adopt a more ag-gressive opportunistic behaviour in accordance with the income-smoothing and capital management approach. Management should be aware of this to implement monitoring and control systems, increasing trustworthiness of financial in-formation for investors' expectations.

Moving toward the expected credit loss model under IFRS 9: capital transitional arrangement and bank systematic risk

This paper examines banks’ option to adopt the capital transitional arrangement (CTA) set out by the Basel Committee on Banking Supervision, in response to the introduction of the International Financial Reporting Standard 9 (IFRS 9), which requires the use of an expected credit loss model instead of an incurred loss model to estimate the impairment of financial assets. Using a sample of publicly listed European banks from 2016 to 2019, we find that bank CTA adoption choice is associated with neutral factors captured by bank-specific fundamental characteristics, and potential opportunistic factors related to regulatory constraints implied by the application of IFRS 9. We further find that banks that adopted the CTA (CTA adopters) decrease their exposure to systematic risk during the transitional period. However, this relationship is only significant in countries with powerful banking authorities. In those with less powerful banking authorities, CTA adopters tend to exercise more aggressively their accounting discretion. Our study is the first to address banks’ voluntary choice to adopt the CTA policy under the mandatory application of IFRS 9.

The Credit-Risk Relevance of Loan Impairments Under IFRS 9 for CDS Pricing: Early Evidence

Since 2018, banks have implemented the expected credit loss (ECL) model under International Financial Reporting Standard (IFRS) 9 to estimate loan losses, which replaces the incurred loss model under International Accounting Standard (IAS) 39. The key novelty of the ECL model is the incorporation of forward-looking information for recognizing accounting loan loss provisions (LLPs), which provides ample room for managerial discretion. Over the period 2014–2019, I first show that the shift to the ECL model improves the timeliness of loan loss recognition. However, under the IFRS 9 regime managers also use their accounting discretion more aggressively over LLP estimates to smooth earnings. I then investigate whether IFRS 9 improves the relevance of LLPs for credit default swap (CDS) pricing. I report that LLPs under IFRS 9 are incrementally more relevant than under IAS 39 for CDS pricing but mostly concentrated amongst banks with weaker pre-IFRS 9 information environments. I further show that under the IFRS 9 regime, LLPs are relevant for CDS pricing only when LLPs consistently reflect future expected losses while earnings smoothing via LLP generally impair the credit-risk relevance of LLPs. Finally, I find that strong governance is imperative for providing useful LLP estimates for CDS pricing.

Credit Scoring – General Approach in the IFRS 9 Context

With the coming into force of the standard IFRS 9 – Financial Instruments, in January 2018, financial institutions passed from an incurred loss model to a forward-looking model for the computation of impairment losses. As such, the IFRS 9 models use point-in-time, estimates of Probability of Default and Loss Given Default and provide a more faithful representation of the credit risk at a given as they are based on past experiences as well as the most recent and forecasted economic conditions. However, given the short-term fluctuations in the macroeconomic conditions, the final outcome of the Expected credit loss models is highly volatile due to their sensitivity to the business cycle. With regard to Probability of Default estimation under IFRS 9, the most commonly methods are: Markov Chains, Survival Analysis and single-factor models (Vasicek and Z-Shift). The development of the score-cards is still the same as in the case of the Internal Ratings Based Probability of Default models, encouraging institutions to use the already available credit rating systems and perform adjustment to the calibration. This paper outlines a non-exhaustive list of quantitative validation tests would satisfy the requirements of the IFRS 9 standard.

Loan loss provision models in Brazilian banks

Purpose This paper investigates which loan loss provision (LLP) model [International Accounting Standards39 (IAS39) based on incurred losses and Brazilian Central Bank Generally Accepted Accounting Principles (GAAP) based on a mixed model] presents higher quality in terms of predictability, and which model is less susceptible to earnings management practices using LLP. Design/methodology/approach To test the difference between the explanatory power of the mixed model and incurred loss model in explaining the LLP, this paper runs a two-stage fixed-effect panel regression model to evaluate the association between LLP of each model and variables representatives of non-discretionary aspects related to the quality of the loan portfolio, business cycles and qualitative evidence indicated in each GAAP. Then, this paper tests the relationship between the errors generated in each regression and the discretion of bank managers and banks’ characteristics. Findings This paper finds that the mixed model results in higher R2 demonstrating that the number produced under this regime is more related to observable variables than the number produced under the incurred losses model. Further, this paper finds no evidence that there is a difference in earnings management between the two standards and this paper does not find that banks manage earnings through regulatory capital. Nevertheless, this paper finds that earnings management is higher in private than in listed banks. Originality/value This paper takes advantage of the unique feature of the Brazilian Central Bank regulation to investigate the impact of two different accounting standards on LLP in a perfect setting.

Moving toward the Expected Credit Loss Model under IFRS 9: Capital Transitional Arrangement and Bank Systematic Risk

This paper examines banks’ option to adopt the capital transitional arrangement (CTA) set out by the Basel Committee on Banking Supervision, in response to the introduction of the International Financial Reporting Standard 9 (IFRS 9), which requires the use of an expected credit loss model instead of an incurred loss model to estimate the impairment of financial assets. Using a sample of publicly listed European banks from 2016 to 2019, we find that bank CTA adoption choice is associated with neutral factors captured by bank-specific fundamental characteristics, and potential opportunistic factors related to regulatory constraints implied by the application of IFRS 9. We further find that banks that adopted the CTA (CTA adopters) decrease their exposure to systematic risk during the transitional period. However, this relationship is only significant in countries with powerful banking authorities. In those with less powerful banking authorities, CTA adopters tend to exercise more aggressively their accounting discretion. Our study is the first to address banks’ voluntary choice to adopt the CTA policy under the mandatory application of IFRS 9.

What Do Analysts’ Provision Forecasts Tell Us About Expected Credit Loss Recognition?

We examine the incremental predictive ability and information content of analysts’ provision forecasts to explore the potential effects of the FASB’s new current expected credit loss (CECL) accounting method. Controlling for the recognized loan loss provision, consensus analyst provision forecasts are incrementally associated with future non-performing loans (NPLs) and equity markets returns. This incremental association is increasing in banks’ unconstrained ability to estimate future losses as evidenced by their loan fair value disclosures and the extent of the constraints imposed by the incurred loss model measured by the fraction of heterogeneous loans individually reviewed for impairment. For a sample of analysts that also forecast NPLs, the association between the individual analyst’s provision forecast and future NPLs is increasing in the analyst’s comparative NPL forecasting accuracy. Finally, we find that the association between the analyst’s provision forecast and future NPLs is increasing in EPS forecast errors but decreasing in target price forecast errors. Together these results suggest that the reported provisions under the current incurred loss model do not fully incorporate banks’ information about future losses and that the extent to which this occurs depends both on banks’ ability to forecast expected losses and the constraints imposed by the incurred loss model. These results suggest that analysts forecast future losses beyond those reflected in the recognized provision and that the incremental information in these forecasts and potential CECL provision timeliness effect is greater when the constraints imposed by the incurred loss model are greater.

Innovation of impairment loss allowance model of Indonesian financial accounting standards 71

PurposeThis study aims to develop a high-quality impairment loss allowance model in conformity with Indonesian Financial Accounting Standards 71 (PSAK 71) that has significant contribution to national interests and the banking industry.Design/methodology/approachThe determination of the impairment loss allowance model is settled through 7 stages, using integration of some statistical methods such as Markov chain, exponential smoothing, time series analysis of behavioral inherent trends of probability of default, tail conditional expectation and Monte Carlo simulation.FindingsThe model which is developed by the authors is proven to be a high-quality and reliable model. By using the model, it can be shown that the implementation of the expected credit losses model on Indonesian Financial Accounting Standards 71 is more prudent than the implementation of the incurred loss model on Indonesian Financial Accounting Standards 55.Research limitations/implicationsDetermination of defaults was based on days past due, and the analysis in this study did not touch the aspects of hedge accounting in general.Practical implicationsThis developed model will contribute significantly to national interests as a source of reference for other banks operating in Indonesia in calculating impairment loss allowance (CKPN) and can be used by the Financial Services Authority of Indonesia (OJK) as a guideline in assessing the formation of impairment loss allowance for banks operating in Indonesia.Originality/valueAs so far there is not yet an available standardized model for calculating impairment loss allowance on the basis of Indonesian Financial Accounting Standards 71, the model developed by the authors will be a new breakthrough in Indonesia.

CECL: Timely Loan Loss Provisioning and Banking Regulation

We investigate how provisioning models affect bank regulation. We study an accuracy vs. timeliness trade-off between an incurred loss model (IL) and a current expected credit loss model (CECL). Relative to IL, CECL improves efficiency by enabling timely intervention to curb inefficient ex post asset-substitution even though the imprecise information of CECL entails false alarms. However, from a real effects perspective, our analysis uncovers a potential cost of CECL: banks respond to timely intervention by originating riskier loans so that timely intervention induces timelier risk-taking. By appropriately tailoring regulatory capital to information about credit losses, the regulator can improve the efficiency of CECL. In particular, we show that regulatory capital under CECL would be looser when early estimates of credit losses are sufficiently precise and/or risk-shifting incentives are not too severe. From a policy perspective, our analysis suggests that better coordination between standard setters and bank regulators could enable the latter to relax capital requirements in order to spur lending.

Expected Loss Model and the Cyclicality of Bank Credit Losses and Capital Ratios

We simulate the evolution of stylised loan portfolios to assess the impact of IFRS 9 and US-GAAP expected loss model (ECL) on the pro-cyclicality of realised losses and capital ratios of banks, relative to the incurred loss model of IAS 39. We focus on the interaction between the changes in loan loss provisions (LLPs) charges (flow channel) and stocks (stock channel) under ECL. Our results show that ECL model smooths the impact of credit losses on profits and capital resources, reducing the pro-cyclicality of capital and leverage ratios, especially under US GAAP. However, when GDP is highly volatile, the large differences in lifetime probabilities of defaults (PDs) between booms and bust cause sharp increases in LLPs in deep downturns, as seen for US banks during the COVID-19 crisis. Volatile GDP makes capital and leverage ratios more pro-cyclical and cause sharper falls in both ratios in deep downturns under US GAAP, compared to IAS 39. IFRS 9 ECL shows less sensitivity to lifetime PDs fluctuations due to the existence of loan stages, and hence reduces the pro-cyclicality of capital and leverage ratios even when GDP is highly volatile.

The Impact of IFRS 9 on Banks’ Loan Loss Provisioning

IFRS 9 introduced a new impairment model based on expected credit losses (ECL) rather than incurred losses to better reflect changes in the credit quality of financial instruments. This paper examines the impact of the ECL model on the predictability of loan loss provisions (LLP) and potential consequences on market discipline. Specifically, I first investigate whether the association between recognized loan loss provisions and objective determinants of the incurred loss model (i.e., changes in non-performing loans and the level of non-performing loans) decreases after the introduction of IFRS 9. Next, I examine whether the arguably less objective LLP under IFRS 9 obscure market participants' ability to monitor the banks’ risk-taking incentives. The empirical findings suggest a decrease in the association between loan loss provisions and the determinants of the incurred loss model in the post-IFRS 9 period, i.e., LLP are based less on objective determinants after IFRS adoption. Furthermore, I find a decrease in the sensitivity of leverage to changes in risk in the post-adoption period of IFRS 9, indicating an attenuated market discipline over risk-taking of banks. The results are mainly driven by banks in countries that allow more smoothing through loan loss provisions as opposed to banks in countries that are more forward-looking. In contrast, I find no changes in the determinants of LLP and market discipline for the benchmark sample of U.S. banks, which were not subject to the same accounting change during the sample period.

Impact of current expected credit loss (CECL) on the US financial institutions – An overview

Failure in the timely adjustment of the reserve levels based on reasonable anticipation of future conditions was turned out to be the major drawback of the Allowance for Loan and Lease Losses (ALLL) accounting standard during the great recession of 2007-2008.1 The major issue during the time of crisis was that the unfavorable economic conditions was not taken into consideration for the calculations of losses under the ALLL method. Because of that reserves were not adjusted for the expected losses in the future. In 2011, The OCC (Office of the Comptroller of the Currency) and Fed (US Federal Reserve) anticipated that the allowances in the industry would increase by 30% to 50%.2 But since the expectations of the economy has changed drastically since then, many economist have predicted that the increase in the industry allowances would not be significant. Keefe, Bruyette & Woods, Inc., an investment banking firm headquartered in New York City predicted in September 2015 that the median increase in ALLL for small and mid-size bank will be meagre 3%.2 After the great recession, Financial Accounting Standards Board (FASB) reviewed how financial institutions are estimating the losses in the ALLL calculation. Various weaknesses in the existing incurred loss model (ALLL) were exposed, which included complexity and delay in recognition of credit losses. At the time of review, The FASB and the International Accounting Standards Board (IASB) discussed and proposed many approaches to correct the damage. Ultimately the final resolution was to make a new accounting standard altogether that should accelerate recognition of credit losses and CECL come into the picture. CECL requires the estimation of expected losses over the life of the loans, and is forward looking approach to make the allowances by giving consideration to the future economic outlooks and the life of the loan. The major expectation of the FASB while introducing this new standard – CECL is that it will improve th

Value-relevance of the regulatory non-GAAP adjustments in the Korean banking industry

ABSTRACTIAS 39 requires firms to use the incurred-loss model for bad debt expenses. However, the Korean Financial Supervisory Commission requires banks to record additional loan-losses based on the expected-loss model. These non-GAAP adjustments include adjustments to book values as well as net income. We examine the incremental value-relevance of these non-GAAP adjustments and fail to find incremental value-relevance over unadjusted IFRS net income. However, the non-GAAP book value adjustment does have a partial, incremental value-relevance over unadjusted book values of equity. In addition, the non-GAAP loan-loss adjustments required by regulators may be disclosed either on the face of the financial statements or in the notes, but the disclosure location also appears to lack value-relevance.

The Effect of Forward‐looking Criteria and IFRS on the Informativeness of Banks’ Loan Loss Allowances: Evidence from Korea

AbstractThis study analyses how forward‐looking criteria (FLC) and International Financial Reporting Standards (IFRS), as well as changes in accounting principles, affect the informativeness of banks’ loan loss allowances. The results indicate that although the relationship between non‐performing loans and loan loss allowances strengthened after the application of FLC, the relationship between non‐performing loans and loan loss allowances weakened and that between net charge‐offs and loan loss allowances strengthened after the application of IFRS, presumably because banks delayed the reflection of insolvent loans on loan loss allowances in the latter case. Moreover, the introduction of IFRS did not improve the ability to predict the future charge‐off scale using loan loss allowances, referred to as the ‘informativeness of loan loss allowances’. This result occurred because IFRS's incurred loss model does not incorporate the impact of macroeconomic situations into loan loss allowances in the early stage, although it does enhance the accuracy of loan loss allowances. By exploring the effect of accounting principles on the determinants of loan loss allowances, this study has implications for the assessment of loan loss allowances, capital adequacy and asset quality for stakeholders such as depositors, creditors, capital markets and financial supervisory authorities.

The cyclicality of loan loss provisions under three different accounting models: the United Kingdom, Spain, and Brazil

ABSTRACT A controversy involving loan loss provisions in banks concerns their relationship with the business cycle. While international accounting standards for recognizing provisions (incurred loss model) would presumably be pro-cyclical, accentuating the effects of the current economic cycle, an alternative model, the expected loss model, has countercyclical characteristics, acting as a buffer against economic imbalances caused by expansionary or contractionary phases in the economy. In Brazil, a mixed accounting model exists, whose behavior is not known to be pro-cyclical or countercyclical. The aim of this research is to analyze the behavior of these accounting models in relation to the business cycle, using an econometric model consisting of financial and macroeconomic variables. The study allowed us to identify the impact of credit risk behavior, earnings management, capital management, Gross Domestic Product (GDP) behavior, and the behavior of the unemployment rate on provisions in countries that use different accounting models. Data from commercial banks in the United Kingdom (incurred loss), in Spain (expected loss), and in Brazil (mixed model) were used, covering the period from 2001 to 2012. Despite the accounting models of the three countries being formed by very different rules regarding possible effects on the business cycles, the results revealed a pro-cyclical behavior of provisions in each country, indicating that when GDP grows, provisions tend to fall and vice versa. The results also revealed other factors influencing the behavior of loan loss provisions, such as earning management.