European banks are bound to take a capital hit when new accounting rules known as IFRS 9 take effect January 1, 2018, but unfinished regulatory reforms and potential high volatility in future provisioning are a bigger threat to capital ratios, accounting and policy experts warn.
Under the latest version of the International Financial Reporting Standards, banks will be required to provision for expected losses, rather than those already incurred. The change is aimed at making lenders more prepared for crises and at enabling them to communicate any financial stress sooner than they could before.
The new rules will have an immediate effect on banks' capital ratios and will result in an increase in provisions, since lenders will have to accrue reserves not just for impaired (or "stage 3") assets, such as nonperforming loans, but also for performing (stage 1) assets and underperforming (stage 2) assets.
The European Banking Authority has estimated the average day one impact on European banks' common equity Tier 1 ratios at 45 basis points and the average increase in provisions at 13%. The maximum CET1 hit is expected to be 75 basis points, with smaller lenders — which tend to use a standardized approach, or SA, to calculate risk-weighted assets — more affected than larger peers that typically use the internal ratings-based approach, or IRB.
Regardless of the credit risk approach, the change to an expected loss accounting model will force banks to hold more capital under existing regulations without a change to their risk profile. The Association for Financial Markets in Europe, or AFME, has said regulators should adjust their treatment of accounting provisions to avoid this problem.
"From our perspective, you should not be accounting for the same risk twice and you should not be holding capital for the same risk twice," Sahir Akbar, director of AFME's prudential regulation division, said in an interview.
A potential double counting of risks could occur due to overlaps in provisions under IFRS 9 and existing regulatory capital requirements. The Basel Committee has come up with transitional rules to be introduced by local supervisors and is also discussing a permanent approach for both IRB and SA banks, with a discussion paper expected in the first quarter of 2018, according to Denisa Mularova, a senior adviser on financial reporting, banking supervision and payments at the European Banking Federation.
"These discussions and a decision on how to avoid double counting of the same risk and work out future prudential rules for treatment of accounting provisions are more important than the day one impact, which will be less significant than previously expected," she said.European banks could also be disadvantaged relative to peers in the U.S., where a similar model to IFRS is to be introduced by the Financial Accounting Standards Board in 2020. Known as the current expected credit loss model, or CECL, the U.S. version matches IFRS9 in seeking to avoid "too little too late" provisioning at banks, but the rules are different, Akbar said.
"Having diverging accounting frameworks prevents convergence in the regulatory standards as well," he said. "European institutions will be recognizing a portion of expected losses at least two years in advance of U.S. institutions, so from our perspective that creates an international level playing field issue."
The AFME has proposed that European regulators consider a "neutralization" of the IFRS 9 rules in the first two years of a proposed five-year transitional period for phasing in the new regime, given that no long-term solution on the regulatory treatment of accounting provisions has been put in place.
IFRS 9 rules will use a point-in-time estimate for expected losses rather than a through-the-cycle measure, which is used for expected losses by the Basel Committee. The point-in-time approach will result in lower provisions in periods of economic growth and higher provisions during a downturn.
But in times of stress, banks are already taking a capital hit as they write off loans and absorb losses, and an expected-loss increase at this point would further burden capital ratios, Akbar said. "So this can amplify or exacerbate a stress because it amplifies the level of losses that you are recognizing at the very time when you need support," he said.
Volatility in provisions is something to watch out for, as banks will be moving assets between Stage 1 and Stage 2 depending on the economy, and a sudden shock would require that they do so more quickly, said Mark Rhys, a partner at Deloitte and co-leader of the global IFRS advisory for banking. However, the new IFRS 9 rules will make the banking system better prepared for crises, Rhys added in an interview.
"That accounting change means the banks' balance sheets will be more robust. Furthermore, they have accumulated more capital over the past 10 years. These two factors together generally will mean the banking system will be stronger," Rhys said. "Under IFRS 9, banks will have more statutory accounting capital and will be able to warn about any problems earlier" than under the previous standards, known as IAS 39.
Moody's also believes that under IFRS9 European banks will be able to cope with losses better during a downturn. "While IFRS 9 results in the faster provision of losses, the recovery in these metrics is also more rapid. Other things being equal, this suggests that banks will be in a stronger position to support growth as the economy recovers," the agency said in an August 3 report.
The relatively benign credit environment in combination with the low interest rates in Europe means that now is a good time to implement the new accounting standard, according to Rhys.