The Basel Committee has published both a consultative paper and a discussion paper on the regulatory treatment of accounting provisions.
Discussion paper: Regulatory treatment of accounting provisions
There are two dynamics in play here. First, the move to expected credit loss (ECL) accounting is likely to increase the overall amount of loan loss provisions in many banks, and to reduce significantly the capital ratios of some banks. The Basel Committee is therefore proposing transitional arrangements under which the “capital shock” is phased in over a three to five year period.
This might take the form of:
I. the full impact of the “day one shock” is phased in over the transition period - an initial upward adjustment to CET1 capital (to compensate for some or all of the shock) is phased out on a straight line amortization basis over the chosen period.
II. applying an amortization approach to a percentage of provisions (based on the reduction in CET1 capital when ECL accounting is introduced) multiplied by the stock of provisions at each reporting date during the transition period; or
III. phasing in the recognition of ECL provisions for regulatory purposes over the transition period, taking into account the likely difference between stage 1 and stage 2 provisions under IFRS 9.
The paper indicates that option (i) is favored, not least because it is the simplest of the three options. Whichever option is eventually chosen, banks will welcome the cushioning of the impact of the move to ECL accounting during the transition period.
Second, the current regulatory treatment of accounting provisions is based on a distinction between specific and general provisions, at least for the standardized approach, whereas ECL accounting does not generate separate calculations of general and specific provisions. And although there is no such distinction for banks using IRB models, (a) these models may not cover all their credit exposures and (b) under the Basel Committee’s proposals for a capital floor, banks using IRB models will also have to calculate what their position would have been under the standardized approach.
Moreover, existing incurred loss approaches to provisioning have given rise to variability in levels of provisions across countries and in the allocation between specific and general provisions.
In its discussion paper, the Basel Committee sets out a number of longer-term options to address these issues, including:
A. retaining the current regulatory treatment of provisions, including the distinction between general and specific provisions, at least over a transition period and possibly on a permanent basis; or
B. retaining a distinction between general and specific provisions, but based on new universally applicable and binding definitions of general and specific provisions; or
C. removing the distinction between general and specific provisions and introducing a standardized regulatory expected loss (EL) concept under the standardized approach. For example, a standardized EL rate could be set for each risk weight under the standardized approach, based on implied probability of default and loss given default rates. This EL amount could then serve as the minimum amount of credit losses that regulators would require banks to cover in the form of CET1 reduction under the Pillar 1 capital requirements. Whatever accounting provisions have been made for credit losses, full recognition up to the regulatory EL rates would be given as long as those provisions reduce CET1 capital. This would in effect introduce a regulatory floor for accounting provisions in the context of capital ratio calculations, and provide consistency in a world of diverse provisioning standards; or
D. developing an alternative approach based on responses to the discussion paper.
The Basel Committee does not express a preference for any of these options, although the space devoted to option (C) and the disadvantages noted under options (A) and (B) might suggest that option (C) is the preferred approach.