Bank regulation: The corrosive effects of IFRS 9
New accounting rules requiring banks to take upfront charges against possible losses through the full life of a loan promise damaging pro-cyclicality.
We are all going to be hearing a lot more this year about IFRS 9, the accounting change set to come into effect in January 2018 that will require banks to recognize expected loan losses even before borrowers miss a single interest or principal repayment.
This is a big change. Previously, to prevent unscrupulous bank managements from smoothing reported earnings with subjective adjustments for expected losses – perhaps to let them hit multi-year performance targets in their pay deals more easily – accounting supervisors insisted impairments only be taken when borrowers actually went into arrears.
The drawback with this approach is the cliff-edge effect. Loans are carried at full value even when it becomes obvious that borrowers will not be able to service them, and assets are treated as perfectly good until the moment they are recognized to be horribly bad.
From next year, banks in Europe and much of the emerging markets must incorporate a charge as soon as they extend a loan for expected losses in the first 12 months of its life. Thereafter, if a borrower suffers a material downgrade in credit quality, banks must take an upfront charge for likely losses over the whole remaining life of the loan. This will hit both reported earnings and capital even if a borrower manages to remain current on debt servicing.
US and Japanese banks will be subject to their own variant, current expected credit loss (CECL), under US GAAP.
There are a number of troubling issues here. One is continuing regulatory uncertainty. There are inconsistencies between IFRS 9 and CECL, as well as an apparent contradiction between banking regulators, led by the Basel committee, now seeking to remove modelling from bank risk-weighted asset and capital calculations by imposing standardized floors, and accountancy supervisors introducing more modelling into those same calculations.
Just when investors in bank equity and debt were hoping the industry had passed peak regulatory uncertainty, a new question arises over the initial hit to common equity tier-1 capital ratios that will result from taking expected loss charges the moment a loan is made.
In a report last November, the European Banking Authority suggested the initial transitional total quantitative impact of IFRS 9 would on average cut banks’ CET1 ratios by around 59 basis points.
In a recent note suggesting that IFRS 9 is an even bigger issue for banks than so-called Basel IV, Barclays analysts gauge cuts of between 80bp and 90bp for the worst affected, such as Bank of Ireland, Danske and Lloyds; hits of 50bp or so for a middle tier including BNP Paribas, Deutsche and Société Générale; and negligible damage for UBS and BBVA.
The Barclays analysts also warn, however, that these initial impacts are just the start. The much bigger worry is greater volatility of both reported earnings and capital ratios, especially in a downturn.
New cliff edge
In a recession, IFRS 9 may prove corrosively pro-cyclical and bring banks to a new cliff edge in which provisions for full lifetime losses overwhelm 12 months’ earnings and so heavily deplete capital, just when capacity is needed to keep good companies alive.
Today’s accounting conventions might inflate RWAs so as to cut banks’ CET1 by 100bp or so in a standard economic downturn. IFRS 9 might bring an immediate 300bp cut in similar circumstances.
Barclays expects stress tests next year to reveal this more clearly in ways that may yet prompt a re-think. European politicians are becoming more assertive that new Basel IV revisions should not restrict the bank lending on which the economy depends. They may now want to consider the possible disinclination of banks to make long-dated loans to certain types of borrowers under IFRS 9, before it is too late.
Banks now have issued a lot of high-trigger contingent capital bonds, and the buffers banks need to protect them will limit their appetite to permit volatility of CET1 ratios. Even while still struggling to cope with legacy NPLs, banks will need to continue building capital.