Compatibility of IFRS and Regulation
Dealing with Loan Loss Provisioning
Presentation for the seminar:
CREDIT RISK MANAGEMENT AND REGULATORY PROVISIONING
IN AN IFRS ENVIRONMENT
Vienna, October 21, 2014
Regulatory Framework for NPL Recognition
and Provisioning – the Case of Croatia
Run-up to Crisis





the Croatian National Bank traditionally applies a wide
array of prudential regulation established through
subordinate legislation (“decisions”)signed by the governor;
the adherence of banks to the decisions is supervised by the
banking supervision departments
prudential regulation is created based on experience with
the 1998-2000 crisis, when a significant part of the banking
system collapsed or was bailed out through massive and
extremely costly government support
that situation created public and political awareness about
risks associated with banking operations
in the 2000-2006 period, due to positive market developments
and consistent regulation, bank portfolios were mopped up
from the crisis impact: NPLs decreased below 5%, and they
were provisioned for by 60%
the effects of prudential regulation improved due to active
application of macro-prudential measures
Regulatory Framework



the Accounting Act – introduces IFRS as standard
accounting practice in Croatia (especially for banks)
the Credit Institutions Act & the Act on the Croatian
National Bank – give supervisory and regulatory powers
to the CNB
the Decision on the Classification of Placements and
Off Balance Sheet Liabilities – creates operational
framework for supervision and accounting of credit risk
Basic Accounting & Prudential Framework before
2013

NPL definition:



non-collateralised: 90 days past due
collateralised: loans which will not be fully recovered, depending on the
estimation of cash flows, but at the latest two years after taking legal actions
by activating collateral
provisioning based on IAS 39 modified by:



compulsory classification as NPL (with at least minimal provisions) 90 days
past due if no legal action was taken
30% compulsory provisioning two years after legal action was taken to
collect the loan
for non-collateralised loans prescribed provisioning depending on past-due
time buckets:





90 – 180 days past due, up to 30%
180 – 270 days past due, 30% up to 70%
270 – 365 days past due, 70% up to 100%
more than 365 days past due, 100%
the interest on NPLs is recognised only if collected (not based on accrual)
Dynamics of NPL and Provision Coverage
2005-2014
NPL ratio and coverage, Croatia
18%
15,7%
16%
14%
56,8%
55%
12,4%
11,2%
54,4%
50%
48,7%
10%
6,2%
6%
46,2%
7,8%
42,8%
5,2%
4,8%
4,9%
48,0%
38,8%
35%
4%
30%
2%
25%
20%
2005
2006
2007
2008
2009
NPL ratio


45%
40%
41,4% 42,6%
0%

65%
60%
13,9%
60,3%
12%
8%
16,6%
2010
2011
2012
2013 1H2014
From 2007 until 2010 NPL
coverage radically decreased
in spite of stable regulation.
As coverage stagnated
subsequently, in 2012 it
became obvious that
prudential regulation isn’t
getting proper traction.
Coverage-right
decrease of coverage is the consequence of inflow of fresh, low provisioned NPLs, but also
of sometimes quite imaginative and very brave collection plans
on-site examination was used as an auxiliary tool with some success; the majority of
coverage increase in 2011 and 2012 was its contribution; active resistance of banks to risk
recognition created extremely high workload for both staff and management of the CNB
the lack of standard NPL definition increased the problem, as banks claimed that our NPL
definition is stricter than in other jurisdictions, so coverage rates are not comparable
Comparative Dynamics I
Bulgaria
Slovenia
18%
15,0%
16%
120%
11,9%
109,9%
100%
100,4%
80%
8%
6,4%
77,1%
6%
2,2%
2,1%
14%
61,4%
58,2%
2,4%
59,5%
63,0%
60%
40%
2%
0%
20%
2007
2008
2009
2010
NPL ratio
2011
60%
8,2%
8%
5,8%
36,9%
4,2%
21,1%
0%
2012
20%
2008
2009
2010
15,1%
6%
80%
13,7%
14%
8%
10,0%
60%
50%
6,3%
49,4%
5,8% 46,1%
Coverage-right
17,6%
15,8%
13,4%
14%
10%
40%
40,3%
40,2%
40,0%
39,6%
30%
2%
80%
70%
16%
64,8%
60%
9,8%
57,1%
50%
6,7%
8%
40,0%
4%
2013
20%
12%
46,0%
2012
18%
70%
11,7%
6,6%
2011
Hungary
Italy
9,4%
40%
30%
NPL ratio
16%
10%
50%
40,6%
23,3%
Coverage-right
12%
45,3%
47,4%
4%
2%
2006
70%
11,8%
10%
6%
90%
80%
15,2%
12%
10%
4%
18,0%
18%
16%
14%
12%
20%
16,6%
46,3%
6%
43,6%
4%
3,0%
37,4%
38,9%
2008
2009
2010
2,6%
2,3%
2006
2007
49,1%
47,8%
40%
30%
2%
0%
20%
2006
2007
2008
2009
NPL ratio
Source: IMF, FSI Tables
2010
2011
Coverage-right
2012
2013
0%
20%
NPL ratio
2011
Coverage-right
2012
2013
Comparative Dynamics II
NPL coverage, Croatia and countries with similar NPL ratio
120 %
100
80
60
40
20
0
2006
2007
Ireland
Croatia
Source: IMF, FSI Tables
2008
2009
Italy
Hungary
2010
2011
Slovenia
Romania
2012
2013
Bulgaria
Issues Noted

major weaknesses recognized in accounting practices were:

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30% provisioning was required two years after taking legal action to collect the
loan; to avoid it, banks simply didn’t take legal action (initiate foreclosure)
after 30% provisioning no additional provisioning was compulsory in spite of
process duration and complexity
“running two year gap” – cash flow from collateral was always expected two
years from now; typical IAS 39 based evaluation was based on the best case
scenario; in supervised banks all estimates of time and sale price of real estate
collateral proved drastically wrong
in evaluation, the real estate value is average of the following three components:
market value, replacement value and present value; market value was based on
the last known similar transaction (frequently before 2008)
discontinued projects were evaluated as completed
auditors confirmed everything, providing that it could technically be presented
under IFRS framework
findings of on-site examinations and shareholders' reactions to these
findings made obvious that the management and the owners jointly
pursue a strategy of optimistic valuation and that auditors are ready to
support it
Change of Regulation


in 2013 amendments to the Decision on the classification of placements were
adopted
those amendments made the following changes:

compulsory provisioning was regulated in detail:


compulsory 10% provisioning 90 days past due (delinquency), if no collateral was activated
compulsory 20% provisioning one year after delinquency, if adequate collateral was not
activated
 compulsory 30% provisioning two years after delinquency, regardless of legal action taken to
activate a collateral;





after accounting for 30%, each 6 months an additional 5% compulsory provisioning
minimum of 1% provisions was established for NPLs
regulation of restructured loans (how to treat them after restructuring, criteria for their
rehabilitation into performing loans)
compulsory minimum haircuts and collection periods were introduced for real estate and
movable property
consecutive compulsory provisions (10%, 20%, 30%) were aimed at motivating
banks to timely start foreclosure, while the additional 5% provisioning was a kind
of “lump sum” correction for all other noticed aberrations from best practice;
others are meant to adjust NPL & forbearance definition to the new definition
approved by EBA BoS (ITS on supervisory reporting regarding forbearance and
non-performing exposures)
Impact of Regulation

the introduction of the Decision amendments was designed to
have full accounting impact by end-2013
 the consequences were obvious:
the cost of provisioning increased from 4 to 6 billion kuna –
roughly for 0,5% of total assets, reaching 89% of operational
results
 the coverage of NPLs by value adjustments increased from 42,6%
to 46,2%


but:

the banking system remained overall profitable
 workout operations and sale of NPLs intensified

banks’ overall and operational results in 1H2014 improved
significantly compared with the same period last year in spite
of stricter regulation
International Financial Reporting Standards
(IFRS) and Prudential Regulation
IFRS



IFRS offer standardised reporting framework
they facilitate transparency of markets and
comparability of different investment opportunities
the optimal allocation of capital depends on proper
application of IFRS
The valuation of certain asset
classes under IFRS is sensitive to
assumptions applied
When Arbitrary decisions influence IFRS
reports?





core portfolios, such as performing loans and all positions created
through arms length transactions are evaluated based on “pure”
IFRS
prudential regulation interferes only with “marginal” high risk
portfolios: NPL & problem loans, litigations, regulatory breaches
and deviations from good corporate governance
the valuation of such positions is based on subjective judgment
about future outcome.
the implementation of prudential standards limits subjective
judgment, increasing comparability of banks’ accounts
prudential reports will materially deviate from IFRS reporting only if
the bank has a very risky business profile.
Reporting is the responsibility of the
management. If they find the regulatory
requirements misleading, they should
adjust the regulatory reporting through a
“statement of differences” for tax and
shareholders reporting purposes.
Preconditions for IFRS Effectiveness


the precondition for accurate accounting is an active
supervision of management reporting by shareholders
motivated to recognize the real value of their assets
in banking, regulation could strongly influence the
rational behavior of shareholders, making them more
relaxed toward overvaluation of bank’s assets
In certain circumstances rational
shareholders would motivate
management and auditors to apply
optimistic assumptions in valuation
of bank’s assets. If so, IFRS loose its
major purpose – providing comparable
accounts
Shareholders’ Benefits from Optimistic
Valuation





if an institution is close to a regulatory minimum, rational
shareholders would attempt to fulfill the regulatory requirement
with “ghost capital”.
the “ghost capital” created through optimistic valuation would
improve regulatory compliance and, due to avoidance of dilution,
(modeled in appendix), increase the expected RoE; additionally, it
would create immediate material benefits for managers
without regulatory interference, such a strategy is financially
superior to prudent accounting
in extreme cases such motivation did create “moral hazard”
without effective regulatory checks an obvious temptation does exist;
to increase the robustness of the system, the regulation should
establish the minimum required level of prudence
IAS 39 offers the possibility to
increase the capital buffer through
an optimistic valuation of
NPL/problem loans.
Protecting Public Interest

prudent bank accounting protects the key public
interest because:



banking is a critical infrastructure of the economy and its
robustness depends on proper accounting
in several countries banks’ managers recently acted as
“fiscal agents”, effectively ruining or at least hampering the
fiscal position
properly acting supervisors/regulators decrease
fiscal risks and improve the financial stability
Historically, financial impact of too
optimistic banking accounting is
obvious and significant, most likely
exceeding any potential adverse impact
of prudential regulation
Conclusion





does prudential regulation distort financial reporting to the level hampering
transparency of financial markets?
we argue that, banks’ management, shareholders and auditors have common
incentive to use “income smoothing”, achieved through optimistic discretion
within IFRS framework; incentives strengthen if bank approaches the regulatory
limits
by limiting such behavior banking regulation improves comparability of accounts
banks’management has tools to rectify the requirements of prudential regulation
in reporting to shareholders
prudential regulation is public and transparent, so it can’t distort public
information; anyway, if distortion appears, its potential adverse effect is only
speculative and obviously smaller than potential effects of improper banking
accounting
IFRS shouldn’t be a
straightjacket for banking
regulation. Their subjective
elements open a possibility
for the banks to
overestimate capital,
potentialy creating a
significant fiscal impact!
Thank you for your attention!
Appendix
Comparative NPV – Retained Earnings
Year 0
Bank has regulatory capital 100 and annual AT profit 10.
Bank has 100 shares.
Discounting factor for calculation of NPV is 5%
All profit goes to retained earnings.
prudent accounting
profit AT
Equity
optimistic accounting
profit per share
NPV
profit AT
Equity
profit per share
0
-50,00
100,00
-0,5000
0
10,00
110,00
0,1000
1
11,00
111,00
0,0550
1
10,00
120,00
0,1000
2
11,22
122,22
0,0561
2
10,20
130,20
0,1020
3
11,44
133,66
0,0572
3
10,40
140,60
0,1040
4
11,67
145,34
0,0584
4
10,61
151,22
0,1061
5
11,91
157,24
0,0595
5
-50,00
101,22
-0,5000
Stock price
1,1907
0,9329
Stock price
2,1620
Scenario:
Scenario:
In year 0 due to increased risk
No recognized risks in year 0
recognized one off provisioning
Loss recognized in year 5 and covered from reserves
cost 60 creating loss 50.
Loss is covered from existent
equity.
Capital shortage was covered
through public issuance of shares.
Fresh capital increased profit for 1
Stock price in year 6 is 20 *PPS (profit per share adjusted for one-off items)
NPV
1,6940
Comparative NPV – Dividend Payout
Year 0
Bank has regulatory capital 100 and annual AT profit 10.
Bank has 100 shares.
Discounting factor for calculation of NPV is 5%
All profit goes to dividend.
prudent accounting
profit AT
Equity
profit per share
optimistic accounting
dividend
NPV
profit AT
Equity
profit per share
dividend
NPV
0
-50,00
100,00
-0,5000
0,0000
0,0000
0
10,00
100,00
0,1000
0,1000
0,1000
1
11,00
100,00
0,0550
0,5000
0,0524
1
10,00
100,00
0,1000
0,1000
0,0952
2
11,00
100,00
0,0550
0,5000
0,0499
2
10,00
100,00
0,0980
0,1000
0,0889
3
11,00
100,00
0,0550
0,5000
0,0475
3
10,00
100,00
0,0980
0,1000
0,0847
4
11,00
100,00
0,0550
0,5000
0,0452
4
10,00
100,00
0,0980
0,1000
0,0806
5
11,00
100,00
0,0550
0,5000
0,0431
5
-50,00
100,00
-0,5000
-0,5000
-0,3918
0,2381
Stock price
1,1000
0,8619
NPV CF
0,0576
Stock price
2,0000
1,1000
NPV CF
Scenario:
Scenario:
In year 0 due to increased risk
No recognized risks in year 0
recognized one off provisioning
Loss recognized in year 5 and covered by shareholders
cost 60 creating loss 50.
Loss is covered from existent
equity.
Capital shortage was covered
through public issuance of shares.
Fresh capital increased profit for 1
Stock price in year 6 is 20 *PPS
1,5671
1,6247
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