Roldán Alegre, José María

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Repositorio Institucional de la Biblioteca del Banco de España

Dynamic provisioning in SpainJosé María RoldánDirector General, Banking RegulationBanco de EspañaJesús SaurinaDirector, Financial Stability DepartmentBanco de EspañaIASB Meeting London, 17 June 20092Dynamic provisionsTwo approaches to dynamic provisionsEconomic approachAccounting approachBoth are consistent and complementary, reinforcing each otherDynamic/statistical/general loan loss provisionsThe substance much more important than the name3Dynamic provisions-SummarySet aside in mid-2000; modified in 2004 (to be consistent with IFRS)Spanish LLP cover the increase in credit risk/lossesTake into account the transition from collective assessment of losses to individually identified lossesBased on extensive research and statistics on historical loan loss experience for bank loan portfolios in SpainTransparent mechanism4Economic approachFinancial markets have imperfectionsMiss-pricing of risksUnder-pricing of risks due to over-optimism(i.e. no more cycles, liquidity flooding,…)difficult to deny it the years before the current crisissearch for yieldOverpricing of risks due to over-pessimismcollective failure: coordination problemsStrong competition across banks and between banks and non-bank financial institutions enhances risk miss-pricing5Economic approachBanking supervisors know that banks’ lending mistakes are more prevalent during upturnsBorrowers and lenders are overconfident about investment projects Banks’ over optimism implies lower lending standardsDuring recessions, banks suddenly turn very conservative and tighten lending standards Lending cycle with impact on the real economy6Economic approachThere is ample empirical evidence of looser credit standards during expansionsRiskier loans granted when credit expands fastUnder-pricing of credit risk Banking supervisors’ concerns are well rooted both in theoretical and empirical groundNeed of a tool to cope with the potential problems due to rapid credit growth/under-pricing of riskOne answer is dynamic provisions7Accounting frameworkThe provisioning framework in Spain refers to the “collective assessment for impairment”Regulation requires institutions to develop internal methodologies to estimate impairment in the loan portfolio (whether specific transactions or collective assessment)For banks which do not have their own model, Banco de España (BdE) provides a model based on the historical credit loss information obtained from the BdE’s Central Credit RegisterBanks are developing their own models to calculate loan loss provisions, but they have not been verified by Banco de España yet8Accounting frameworkBdE model applies to cover incurred losses only for credit activity in Spainnot possible to apply Spanish parameters to loans granted abroad by Spanish banksBdE model is a statistical modelBdE model uses historical information to set out provisioning levels at the balance sheet dateThe model uses historical loss data information for homogenous groups of loansCredit cards, mortgages, loans to SMEs, loans to governments,…Historical means a full lending cycle9Spanish provisioning model vs the IFRSThe Spanish dynamic provisioning model refers to the “collective assessment for impairment”The key assumption is the transition from the collective assessment to the individually impaired assets and specific provisionsIn the BdE model it is assumed that during periods of intensive credit risk increase (under-pricing of risk/increase in incurred losses), it takes longer for provisions to transit from collective assessment to specific provisionsIn other periods, the individually impaired assets are easily identified and the transition period from collective assessment to specific provision is shorterWe believe that, although IAS 39 does not specifically address this issue, it does not rule out this assumption10Accounting frameworkBanks must make provisions against the credit growth according to parameter α which is the average estimate of the credit loss (“collective assessment for impairment” in a year neutral from a cyclical perspective)α varies across six homogeneous groups of loans according to our historical information on credit lossesAs credit risk or incurred losses not yet identified in a specific loan translate into specific loan losses at a different speed depending on the business cycle, α is supplemented by a β parameter11Accounting frameworkβ is the historical average specific provision of each group of loans. By comparing β with the current level of specific provisions, banks can assess the speed at which “unspecific” (collective) incurred losses evolve into specific losses for individual assetsIn periods of expanding credit risk/under-pricing of risk/increase in incurred collective losses the difference is positive, so is the second component of the general  provisionIn periods when specific losses are much more easily identified in individual loans, the difference reverses and thus this component subtracts from the α component and may cause the generic provision fund to be drawn downThe Spanish general provision also includes a cap in the amount of the general fund being build up…to avoid excess provisioning… as well as a floorto cover incurred losses not yet individually identified even in a recession12Specific mechanicsCurrently, we have specific provisions and general provisionsGeneral provisions are set aside according to:Ct is the stock of loans and ∆Ct its variationα which is the average estimate of the credit loss in a year neutral from a cyclical perspectiveβ is the historical average specific provisionttttt CCespedotCgendot ).(. −+∆= βα13TransparencyBanks are required to disclose the amount of the dynamic provision, apart from the specific provisionThus, users of accounting statements can “undo” the impact of the dynamic provision on the P&LOur aim is that financial statements (balance sheet and, in particular, the P&L) properly reflect the true financial situation on the bankTo recognize the credit risk/losses when they appearAvoid biases in profits, dividends, and bonusesTo deliver the proper incentives to investors As well as to bank managers14Cohort exampleWe present a  very simple exercise to show how loan loss provisisons work in Spain It is based on a set of restrictive assumptionsWith this exercise we try to respond to the following question:“What happens to a cohort of 1,000 loans from the date they are granted to the day the last one is paid back or defaults?”15The Cohort ModelAssumptions :At t=1 the Bank starts its business with a portfolio of 1,000 homogeneous loans with a nominal value of 100 currency units (CU) each. Thus, the bank begins with a value of its portfolio of 100,000 CUAll loans are classified in an homogeneous group of risk (uncollateralized loans to firms), with an associated α parameter of 1.80% and a β parameter of 0.65%Every loan is amortized by a constant amount that derives from aFrench amortization system with a fixed interest rate (of 6%) and a fixed maturity (of 10 years)This is a simple way to “close” the loan book in 10 years 16The Cohort ModelDynamics for impairments: Every period a proportion of pt loans becomes impaired. Of these loans, a proportion of q (fixed to 60%) remains impaired the next year. Of these impaired loans, again aproportion of q loans remains impaired. At the end of the second year impaired, the remaining amount is considered a loss, and it is dropped out of the balance sheet of the bank (i.e. it is not possible to recover any left amount of the impaired asset in the future)The specific provision is assumed to be equal to 25% of the total amount of the impaired loan the first year that it is classified as doubtful. This proportion increases to 100% the second year17The Cohort ModelThe cumulated final losses amount is close to the initial theoretical general provision set aside in year 1 and also to the effective general fund established in year 1YearLoans (Number)Beginning Loans (CU)Ending Loans (CU) pCumulatedLosses(CU)NPL (%)Specific Provission (CU)Specific Fund(CU)αΔLoans(CU)βLoans(CU)Theoret. General Prov.(CU)Theoret. General Fund(CU)αLoans(CU)General Prov.(CU)General Fund (CU)(Spec.+Gen.Fund)/ Loans  (%)1 1,000 100,000.0 92,413 0 0 0.00 0 0 1,663 601 2,264 2,264 1,663 2,079 2,079 2.252 1,000 92,413.2 84,371 0 0 0.00 0 0 -145 548 404 2,483 1,519 -181 1,898 2.253 1,000 84,371.2 75,932 1 0 1.11 211 211 -152 494 131 2,029 1,367 -190 1,708 2.534 1,000 75,846.7 67,088 2 0 2.90 740 866 -159 436 -463 1,245 1,208 -463 1,245 3.155 997 66,810.7 57,639 4 277 5.97 1,277 1,486 -170 375 -1,073 173 1,038 -1,073 173 2.886 991 57,232.5 47,303 2 783 5.55 1,424 1,809 -186 307 -1,303 -1,130 851 -173 0 3.827 978 47,079.7 35,846 1 1,769 2.94 578 735 -206 233 -551 -551 645 0 0 2.058 972 36,317.7 24,323 0 2,170 0.97 177 235 -207 158 -226 -226 438 0 0 0.979 969 24,909.9 12,420 0 2,342 0.00 0 0 -214 81 -134 -134 224 0 0 0.0010 969 12,817.7 0 0 2,342 - 0 0 -224 0 -224 -224 0 0 0 -Specific Provission General Provission18The Cohort Model0.00 1000.00 2000.00 3000.00 4000.00 5000.00 6000.00 7000.00 1 2 3 4 5 6 7 8 9 10Interest, net of loan losses, set oneSpanish approach Incurred loss19The Cohort ModelThe difference in the interest net of loan losses introduced by the Spanish approach is more important the first yearThe reason is that we are assuming that the bank starts from scratch without any previous general fund, thus, it is established the first yearBut it is also the result of the NPL profile assumed in the exercise If we start the loan portfolio in a less favorable environment, such as the current situation in many countries, the difference is much lower, if anyTherefore, the difference in profits as a result of the introduction of a system of general provisions similar to the current one in Spain depends on the conditions of the lending cycle and, in any case, there seems to be a significant difference only in the first year20The Cohort Model-High initial NPLs0.00 500.00 1000.00 1500.00 2000.00 2500.00 3000.00 3500.00 4000.00 4500.00 5000.00 1 2 3 4 5 6 7 8 9 10Interest, net of loan losses, set oneSpanish approach Incurred loss21The Cycle ModelThe cohort model is static. It is possible to introduce more dynamism in the loan portfolio, increasing its realism18 cohorts are considered, one by year. We have a kind of overlapping generation model where each generation is a cohort identical to the one described in the previous sectionThe Bank starts its business at t=-6 with a portfolio of 1,000 homogeneous loans with a value of 100 currency units (CU) each. Until t=0 1,000 new homogeneous loans are granted every year. From year 1 onwards, the number of new loans granted is related to the economic conditions assumedi.e. loans increase more in upturns than in downturns, thus, we have a lending cycle22The Cycle ModelThe general fund increases until year 0 but, starting in year 1,declines. The sudden and deep increase in specific provisions (i.e. a speed up of individually identified losses) explains thesharp decline in the general fund. The general fund starts to recover in year 6 when the recession is well behind and the portfolio growth resumes.YearLoans (Number)Beginning Loans (CU)Ending Loans (CU)NPL (%)Specific Provission (CU)Specific Fund(CU)αΔLoans(CU)βLoans(CU)Theoretical General Prov.(CU)Theoretical General Fund(CU)αLoans(CU)General Prov.(CU)General Fund (CU)(Spec.+Gen.Fund)/Loans (%)0 6,997 523,754 525,298 1.38 2,321 4,681 855 3,414 1,948 12,699 9,455 1,068 11,819 3.141 7,988 560,072 563,040 3.41 5,100 8,288 679 3,660 -761 11,058 10,135 -761 11,058 3.442 8,776 564,982 571,967 7.48 14,234 19,453 161 3,718 -10,355 703 10,295 -10,355 703 3.523 9,761 579,317 587,876 5.83 16,005 27,684 286 3,821 -11,898 -11,195 10,582 -703 0 4.714 11,246 630,925 640,778 4.87 6,122 24,250 952 4,165 -1,005 -1,005 11,534 0 0 3.785 12,677 665,250 688,884 3.91 4,789 24,693 866 4,478 555 555 12,400 555 555 3.676 14,111 691,254 738,145 3.00 2,216 19,354 887 4,798 3,469 4,023 13,287 3,469 4,023 3.177 14,907 760,334 801,581 1.68 2,727 10,076 1,142 5,210 3,625 7,648 14,428 3,625 7,648 2.218 15,704 822,690 863,723 1.48 3,209 9,075 1,119 5,614 3,524 11,172 15,547 3,524 11,172 2.349 16,535 877,917 919,385 1.32 3,554 7,953 1,002 5,976 3,424 14,597 16,549 3,424 14,597 2.4510 17,364 925,589 968,499 1.39 3,895 8,992 884 6,295 3,284 17,881 17,433 3,284 17,881 2.77Specific Provission General Provission23The Cycle Model010,00020,00030,00040,00050,00060,00070,00080,00090,000100,0001 2 3 4 5 6 7 8 9 10Interest, net of loan losses, set oneSpanish approach Incurred loss24ConclusionsThe Spanish system allows for an earlier detection of credit losses building up in the banks’ loan portfolioIt is a transparent system (rule-based, formula based, with disclosures) and provides information that is comparable across banksEarly warning system for financial statement usersit signals the build up of credit risk and credit lossesIt delivers the proper information to investors to gauge the true financial condition of the firm The proper recognition of the increase in credit risk/collective incurred losses since the inception of the dynamic provision, has been very useful for Spanish banks under the current crisis…… although it is not a silver bullet25ANNEX26Specific mechanicsThe former formula is a simplified way of presenting thingsIn fact,  α and  β are assigned according to the six risk buckets or six homogeneous risk categoriesThe parameter vectors are:(0%; 0.6%; 1.5%; 1.8%; 2%; 2.5%) for α(0%; 0.11%; 0.44%; 0.65%; 1.1% y 1.64%) for βSix homogeneous groups:1. zero risk (cash, public sector debt)2. home mortgages with LTV below 80%, corporates with rating A or above3. loans with real guarantees and home mortgages with LTV above 80%4. rest of loans, including corporates and SMEs5. consumer durables financing6. credit cards and overdrafts27Specific mechanismThe formula of the new general provision is:There is no need to know which is the exact position in the cycle. That is endogenously provided by current specific provisions that, by definition are closely tied to non-performing loans, a variable closely linked to the lending and the business cycleIt is easy to look backwards and stablish the length of the last lending cycle and, therefore, the average of the cycle specific provision (the β) ⎟⎠⎞⎜⎝⎛−+∆=⎟⎟⎠⎞⎜⎜⎝⎛−+∆= ∑∑∑∑====61616161...ititiiitiiti ititiiitit espedotCCCCespedotCgendot βαβαCredit across the six risk categories. Dec. 2004Without riskLow riskMedium-low riskMedium riskMedium-high riskHigh risk 29Fact sheet (1)Total loan loss provisions at a consolidated level at the end of2007 were 1.33% of total consolidated assetsThe ratio of bank capital and those total assets was 5.78% Spanish banks did not have conduits or SIVs, thus, the amount of off-balance sheet assets was very limited At the end of 2007, Spanish banks at a consolidated level had 1.20% of general provisions over total credit grantedThe ratio of general provisions to credit subject to positivedynamic provisioning requirements was 1.44% at the end of 2007 at a consolidated levelGeneral provisions were 73.2% of total loan loss provisions at that timeUsing June-08 data, for those banks applying IRB methods, total loan loss provisions exceeded expected losses by 57.8%, while the excess of general provisions was 22.36%30Fact sheet (2)The ratio of general provisions over total credit subject to thedynamic provision at the end of 2007 for individual balance sheetswas 1.22%If we exclude those exposures with 0% weighting, the coverage ratio climbs to 1.59%For non-consolidated data in Spain, the generic provisions were78.9% of total provisions at the end of 2007Parameters imply that for a new (traditional) mortgage (LTV up to 80%), the bank has to set aside 0.71% of its amount as a generalprovision that, assuming a 15% LGD, means that the effective coverage raised is up to a non-performing loan ratio of close to 4.75%, which compares with 3.85% NPL ratio for mortgages at the peak of the last recession in 1993, while the LGD was around0%31Recent developmentsG20 Leaders’ Statement at the London Summit in April 2009 calls for “accounting standard setters to work urgently with supervisors and regulators to improve standards on valuation and provisioning”Turner Reviewa non-distributable Economic Cycle Reserve…… that should appear somewhere in the P&LOthers (OCC) argue for more judgment to be usedBy firms as well as by auditorsProvisions based on expected losses is another possibility beingdiscussed

Dynamic provisioning in Spain

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Dynamic provisioning in Spain

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