Loan Loss Provisioning


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A briefing on the IFRS proposal for an Expected Loss Model

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  • My discussion tonight is about a joint proposal by IFRS and FASB that would dramatically revise the way companies, specifically banks, account for doubtful accounts.At issue is the central question: when do you reserve for a loss, and how much do you reserve?My discussion will focus on the banking industry. As a result, I may use industry terms that differ slightly from classic accounting terminology.
  • The Allowance for Loan Loss. Reserve for Bad Debts. Provision for Loss.This is an expense banks and credit unions accrue when they believe someone may default on a loan. It is an estimate by banks of how much they would charge off of their books in the event the loan moves into default.The current standard is to recognize the loss before it happens but as close to the default as they can predict.Banks do it this way because it affects Net Income.
  • In this balance sheet, we have three columns. Provisioning at 5-percent, 10-percent, and 20-percent of Loan Income.As you can see, by reserving for bad loans, it reduces net income.Historically, however, the percentage of loans that actually default is much smaller than what banks reserve.
  • This graph shows net charge-offs over the past decade. These numbers come from the Credit Union industry. The 2013 number is an estimate.In the United States since 2004, credit unions charged off an average of 0.83% of total loans.Charge-offs peaked in 2009, following the mortgage implosion in 2008. Despite this fact, charge-offs were just 1 ¼ percent.
  • Here are the four major types of loans—again from the Credit Union industry.Credit Card defaults clearly are the major problem, and this holds true for banks. The mortgage crisis was an outlier historically.Second mortgage charge-offs were higher among banks.
  • The G20 nations asked IASB and FASB to reconsider how the financial industry makes a provision for defaults.The current IFRS proposal will change parts of the guidance on Financial Instruments.It will replace the section on recognition.Get your comments in by July 5th.
  • The new proposal would be more timely in its recognition of a loss.
  • While the proposal is a response to the mortgage lending, the proposal would affect any entity that holds a financial asset that is not accounted for at fair value.Auto lending, HELOCs, and personal guarantees come to mind.
  • Stage I: As soon as a financial instrument is purchased, recognize 12 month expected loss. Book the S/T loss before you lose.Stage II: As instrument deteriorates below investment grade, recognize lifetime expected loss. Book the L/T loss before you lose.Stage III: At impairment, adjust the gross carrying amount for the loan loss12 Month Expected Credit Loss: The possibility of a default. Not expected cash shortfalls. No credit losses forecasted to default.Lifetime Expected Credit Loss: Expected present value credit losses.
  • Loan Loss Provisioning

    1. 1. Brian S. McDaniel
    2. 2. DefinitionReserve for Bad DebtsValuation reserve established andmaintained by charges against abank’s operating incomeEstimate of uncollectible amountsused to reduce the book value ofloans and leases to the amountthat a bank expects to collect.
    3. 3. Income 5% 10% 20%Loan Income 50,000$ 50,000$ 50,000$Other Income 3,500$ 3,500$ 3,500$Total Income 53,500$ 53,500$ 53,500$Operating ExpensesLoan Servicing 500$ 500$ 500$Provision for Loss 2,500$ 5,000$ 10,000$Total Expenses 3,000$ 5,500$ 10,500$Net Operating Income 50,500$ 48,000$ 43,000$Non-Operating ExpensesInterest Paid to Depositors 500$ 500$ 500$(Gain) Loss on Sale of Investment -$ -$ -$Total Non-Operating Expenses 500$ 500$ 500$Net Income 50,000$ 47,500$ 42,500$
    4. 4. 0.53%0.54%0.45%0.51%0.81%1.21%1.14%0.91%0.73%0.60%0.00%0.20%0.40%0.60%0.80%1.00%1.20%1.40%2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
    5. 5. 0.00%0.50%1.00%1.50%2.00%2.50%3.00%3.50%4.00%4.50%5.00%Credit Card FirstMortgageSecondMortgageBusinessLoans200720082009201020112012
    6. 6. Made at the request of theG20WillChange IFRS 9: Financial InstrumentsWill Replace IFRS 39: RecognitionComment Deadline: 5 July 2013
    7. 7.  The existing modeldelays recognitionof credit losses untilthere is evidence ofa credit loss event
    8. 8.  Expected creditlosses would beupdated at eachreporting date toreflect changes incredit quality
    9. 9.  All entities that holdfinancial assets orcommitments toextend credit thatare not accountedfor at fair value
    10. 10. Stage I12 MonthExpectedCreditLossEffective Intereston Gross CarryingAmountStage IILifetimeExpectedCreditLossesEffective Intereston Gross CarryingAmountStage IIILifetimeExpectedCreditLossesEffective Intereston AmortizedCost CarryingAmount
    11. 11.  GAAP and IFRS use Incurred Loss Model Both want Expected Loss Model FASB Proposed Different Model An entity would not measure loss allowance for anyfinancial instrument using 12 Month Expected CreditLoss provisions in IASB proposal
    12. 12. • This is a great idea!IFRS/FASB• Are you kidding me?Industry
    13. 13. 