Expected Credit Loss: The New Way Banks Must Recognise Shifting Credit Risk

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In OTC derivatives trading in Australia – are you playing by the rules? we looked at how new regulatory requirements have been introduced for some financial products (in that case, over-the-counter (OTC) derivatives), in the wake of the global financial crisis. New reporting rules and ‘mandatory clearing’ are intended to make the risks in these trades more transparent.

credit risk

By Dr. Drew Donnelly, Compliance Quarter

Similarly, today’s topic concerns new rules intended to increase the transparency in the risk profile of a bank’s (or any other authorised deposit-taking institution’s), loan portfolio. On July 4, the Australian Prudential Regulation Authority (APRA) issued a letter to all Authorised Deposit-Taking Institutions titled Provisions for Regulatory Purposes and AASB 9 Financial Instruments. It sets out how APRA will apply a new ‘expected credit loss’ model to authorised deposit-taking institutions (ADIs) requiring them to be pro-active and forward-looking in assessing credit risk and setting aside enough provision for possible future losses.

We offer a general explanation of this guidance below

 

New accounting standards…

APRA’s new approach to credit risk is related to the impending introduction of a new accounting standard, AASB 9. This new accounting standard becomes mandatory from January 1 2018, but is already in use by many banks.

A key change in AASB 9, following changes in international accounting standards, is a new approach to impairment. Impairment recognises the reduction in the value of an asset. In the case of a financial asset such as a loan, this is the increased risk that cashflows on that loan will not be realised.

Until recently, impairment was measured using an “incurred cost” model. This means an asset was only impaired when various ‘triggering events’ occurred, such as defaulting on interest payments. This meant that credit losses were often reported too late to inform investors and may have resulted in banks setting aside insufficient ‘provision’ in case of loan failure.

The new ‘expected credit loss’ model, by contrast, is forward-looking, requiring the business to account for the probability of future losses occurring, even in the absence of particular triggering events.

 

…have a flow-on effect to prudential supervision from APRA…

APRA’s supervisory role is broad, it defines its purpose thus:

“to establish and enforce prudential standards and practices designed to ensure that, under all reasonable circumstances, financial promises made by institutions we supervise are met within a stable, efficient and competitive financial system”.

Through prudential regulation (particularly APS 220) APRA requires ADIs to adopt prudent credit risk management policies and procedures, and to “maintain provisions and reserves adequate to absorb existing and estimated future credit losses into its business”.

APRA requires that ADIs use two different ‘accounts’ to provide for possible loss. General provision for loss requires keeping a prudent level of ‘General Reserve for Credit Losses’ (GRCL). The ADI must also separately monitor “specific provisions”, in relation to specific impairment risks, and together these must be sufficient to absorb all credit losses.

 

…and its latest guidance

APRA’s latest guidance is concerned with how, in light of the new impairment model, expected credit loss should be distributed between those two separate kinds of provision. APRA’s approach has three stages, depending on the level of increase in credit risk.

  • Stage 1: where loans are performing and, there is no significant increase in credit risk, 12-month expected credit loss must be allocated to GRCL. This is losses that would occur (on a weighted basis) from default within the next 12 months.
  • Stage 2: Where loans are underperforming and there is a significant increase in credit risk, this must be allocated to “specific provision” based on lifetime expected credit risk (not just 12 months).
  • Stage 3: Where loans are non-performing (for example, if there has been several triggering events), the loss must be allocated to “specific provision” on the basis of lifetime expected credit risk.

It should be noted that APRA’s prudential requirements have some differences with what is permitted for accounting purposes under AASB 9.

Read APRA’s letter.

For advice on your specific obligations, contact an accountant or other financial compliance specialist

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