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:
These three options are set out in the consultative paper, with an indication that the Basel Committee favors option (i), 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 variability in the allocation of provisions 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:
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) suggest that option (C) is the preferred approach.
Consultative document: Regulatory treatment of accounting provisions – interim approach and transitional arrangements (PDF 317 KB)
Discussion paper: Regulatory treatment of accounting provisions (PDF 310 KB)
EBA draft guidelines on credit risk management and accounting for expected credit losses.