Loan classification and provisioning – Overview paper of current practices in 26 countries

Katia D’Hulster

Overview paper objectivesa. NPL definition comparison b. Interactions with IFRSc. Good practice and further work

Objectives

Countries covered in the overview paper Host countries: Albania, Bosnia Herzegovina,

Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Georgia, Kosovo, Latvia, Lithuania, Macedonia, Montenegro, Poland, Romania, Serbia, Slovakia, Slovenia

Home countries: Austria, Denmark, France, Germany, Italy, Greece, Norway and Sweden

General overview

Basis for classification World Bank survey 2011-2012 Desk review of regulation Expert judgment where needed

Comments and suggestions on individual country classifications welcome

General comments

I. NPL definition comparison

“..payment of principal and interest past due for more than 90 days”

“..interest payments equal to 90 days interest or more have been capitalized, refinanced or rolled over..”

“…in addition, NPLs should also include those loans with payments less than 90 days past due that are recognized as non performing under the national supervisory guidance. That is, evidence exists to classify a loan as non performing even in the absence of the 90 days past due …”

Source: Financial Soundness Indicators: Compilation Guide

NPL definition comparison

Dimensions analyzed1. Asset classification systems2. Defining non performing loans3. Loan forbearance4. Multiple loans to a single borrower5. Collateral valuation6. Write offsOther dimensions7. Exposure measurement 8. …

I. NPL definition comparison

1. Asset classification systems

Yes; 72%

No; 28%

Do you have an asset classification system?

Government exposures are generally included in the asset classification systemOf those that have an asset classification system, 72 % have a system that covers government exposures.

The majority of the 26 countries in the survey have an asset classification system

1. Asset classification systems

Asset classification systems are more common in host countries14 out of the 18 countries in the survey have an asset classification system, while only 4 out of the 7 home countries have one.

Generally: five buckets and worst three buckets: substandard, doubtful and loss are generally NPL

…but difficult to draw conclusions

90 days past due or unlikely to pay

Unlikely to pay, with or without realization of collateral? Materiality thresholds, grace periods…

Very little guidance on exit criteria

2. Defining non performing loans

30 days, 23%

60 days, 31%

90 days, 31%

other, 15%

Number of days past due for classification as substandard

90 days , 40%

180 days, 23%

270 days, 16%

other, 15%

Number of days past due for classification as doubtful

2. Defining non performing loans

180 days , 38%

365 days, 31%

other, 31%

Number of days past due for classification as loss

Generally referred to as “restructuring” Wide variety in the definitions Generally 2 components: change in contract

terms and financial difficulty of the borrower “Embedded” forbearance clauses Sometimes reduction in cash flows or loss

required Forborne loans not always non performing

loans

3. Loan forbearance

Yes , 83%

No , 17%

Do regulations require forborne loans to be classified as non performing ?

Review of credit worthiness45% of the surveyed countries require a review of the credit worthiness of the borrower before it can be upgraded to performing exposures.

3. Loan forbearance

yes , 32%

no, 63%

other , 5%

Are banks allowed to upgrade the classification of a loan immediately

after it has been forborne ?

Host countries are stricter than home countries10 host countries out of 15 do not allow immediate upgrade while 2 out of 4 home countries allow immediate upgrade after forbearance.

3. Loan forbearance

Yes , 74%

No, 22%

Not specified,

4%

Are multiple loans to a single borrower all classified as non performing?

4. Multiple loans to a single borrower

EBA position on product vs customer viewThe EBA proposes to assess NPL exposures on an individual basis (transaction approach), or when more than 20% of the retail borrower’s total exposure is non performing, based on the debtor’s approach.

Yes , 56%

No, 5%

Not specified,

39%

Do the provisioning requirements allow the value of collateral to be deducted from the amount of the loan before provisioning is applied?

5. Collateral valuation

Yes , 70%

No, 30%

Of those countries that consider collateral, is there any differentiation between prime and other collateral ?

Some countries allow exposure upgrades because of the existence of good quality collateral

e.g. 120 days past due can be upgraded into 90 days past due because of prime collateral.

Other countries allow split of exposure into collateralized part and uncollateralized part

e.g. collateralized part: substandarduncollateralized part: doubtful

4. Collateral valuation

Yes , 10%

No, 90%

Do regulators require banks to write off non performing loans after a specific time

period ?

6. Write offs

Good practice for write offsIt is good practice to require the Board to review the NPL portfolio every 6 months and to decide if exposures need to be written off.

Requiring prompt write offs of fully provided and uncollectable loans is an area where prudential supervisors and tax authorities can provide the right incentives to banks.

II. Prudential impact of IFRS implementation

1. Basel: Expected and unexpected losses2. Basel vs IFRS 3. Provisioning 4. Accrued interest 5. Other issues when transitioning

Prudential impact of IFRS implementation

1. Expected and unexpected losses

1. Expected and unexpected losses

Basel - Expected Losses IAS 39 - Incurred losses

AnticipatedForward looking

Trigger eventObjective evidence of impairment

One year horizon Lifetime of the loan

Averages of the economic cycleOr stressed conditions

Current economic conditions

Definition of “default” is generally 90 days past due (Basel II para 452 and 453)

Breach of contract

Economic loss Carrying value of loan minus PV of cash flow discounted at effective rate

Exposure at default includes future draws

Exposure is balance sheet amount

2. Basel vs IFRS

Expected losses and incurred losses - overlaps

Expert judgment layer

Historical data

Segmentation

2. Basel vs IFRS

IFRS 9 from 2018

Stage 1: 12 months ECLStage 2: lifetime ECLStage 3: lifetime ECL

Relative assessment of riskRebuttable assumption of default at 90d past due

2. Basel vs IFRS

3. Provisioning

Yes , 52%No, 48%

Are there minimum levels of specific provisions set by the supervisor?

3. Provisioning

< 20%

20%

> 20%

Substandard provisioning levels

< 50%, 39%

50%, 46%

>50%, 15%

Doubtful provisioning levels

100%, 85%

< 100%, 15%

Loss provisioning levels

3. Provisioning

4. Accrued interest

Yes , 26%

No, 53%

Not specif., 21%

Does accrued unpaid interest enter the income statement while the loan is

classified as non performing?

Yes , 26%

No, 53%

Not specif., 21%

Does accrued unpaid interest enter the income statement while the loan is

classified as non performing?

How to deal with the “excess” regulatory provisions when starting IFRS?

Asset classification systems generally compliant with IFRS

..but regulatory provisioning may have to be revisited

Adjust using capital ratio (Pillar 2) or implement regulatory provisioning by retained earnings when under-provided

Other issues when transitioning to IFRS

III. Good practices and areas for further work

Include government exposures in asset classification and provisioning framework

Require banks to clearly flag and report forborne loans, including keeping track of the number of forbearances for each loan

Report non performing loans using the gross value of the loan, not amount overdue, the value net of provisions or collateral

Include maturity extensions and embedded forbearance clauses in the regulatory definitions of forbearance

Some good practices for supervisors

Perform in depth assessment of bank’s statistical provisioning methodologies and, where applicable, understand the differences with the risk inputs used for the regulatory capital calculation

Include clear qualitative criteria in the definition of default

Define clear criteria for regulatory provisions, not just minimum percentages

Consider incentives to establish prompt write offs of fully provided and uncollectable loans

…

Some good practices for supervisors

Deeper understanding

Regional cooperation

Sharing of knowledge

Regional data collection and benchmarking

Areas for future work

ANNEX

Accrued interest under IAS 39IFRS – With discounting effects

A bank extends a two year loan for 100 Euro (1) on 1 January X0. The principal is to be repaid in two equal installments, at 31 December X0 and X01. No commissions are taken at loan origination, thus the contractual interest rate equals the effective interest rate.

At year-end, interest is accrued at 10% (2)

Accrued interest under IAS 39On 1 January X1, the loan is identified as impaired. The book value of the loan at the time of impairment amounts to 110 Euro (100 principal + 10 accrued interest). The bank assesses the recoverable amount of the loan at 66 Euro, to be received on 31 December X1. The present value of the recoverable amount is 60 Euro (66/(1+10%)=60). The provision to be created is 50 Euro (3)(110 – 60 Euro).

At the end of the second year, the interest accrued is 10% on the net book value of the loan principal, which is now 6 (60x10%).

Accrued interest under IAS 39No discounting effects A bank extends a two year loan for 100 Euro (1) on 1 January X0. The principal is to be repaid in two equal installments, on 31 December X0 and X1.

At year-end, interest is accrued at 10% (2)

Accrued interest under IAS 39On 1 January X1, the loan is identified as impaired. The book value of the loan at the time of impairment amounted to 110Euro (100 principal+10 accrued interest). The bank assesses the recoverable amount of the loan at 66 Euro, to be received on 31 December X1. The provision to be created is 44Euro (3)(110–66 Euro).

On 31 December X1, the interest accrued is 10% on the net book value of the loan principal, which is now 6.6 (66X10%).

Regulatory adjustment is required: 27.4 + 6.6 = 34 This is exactly the result IAS 39 gave, without regulatory adjustment.