IFRS 9 loan loss provisioning faces its first real test

My long held view has been that IFSR 9 adds to the procyclicality of the banking system (see here, here, and here) and that the answer to this aspect of procyclicality lies in the way that capital buffers interact with loan loss provisioning (here, here, and here).

So it was interesting to see an article in the Financial Times overnight headlined “New accounting rules pose threat to banks amid virus outbreak”. The headline may be a bit dramatic but it does draw attention to the IFRS 9 problem I have been concerned with for some time.

The article notes signs of a backlash against the accounting rules with the Association of German Banks lobbying for a “more flexible handling” of risk provisions under IFRS 9 and warning that the accounting requirements could “massively amplify” the impact of the crisis. I agree that the potential exists to amplify the crisis but also side with an unnamed “European banking executive” quoted in the article saying “IFRS 9, I hate it as a rule, but relaxing accounting standards in a crisis just doesn’t look right”.

There may be some scope for flexibility in the application of the accounting standards (not my area of expertise) but that looks to me like a dangerous and slippery path to tread. The better option is for flexibility in the capital requirements, capital buffers in particular. What we are experiencing is exactly the kind of adverse scenario that capital buffers are intended to absorb and so we should expect them to decline as loan loss provisions increase and revenue declines. More importantly we should be seeing this as a sign that the extra capital put in place post the GFC is performing its assigned task and not a sign, in and of itself, indicating distress.

This experience will also hopefully reinforce the case for ensuring that the default position is that the Counter Cyclical Capital Buffer be in place well before there are any signs that it might be required. APRA announced that it was looking at this policy in an announcement in December 2019 but sadly has not had the opportunity to fully explore the policy initiative and implement it.


The answer is more loan loss provisions, what was the question?

I had been intending to write a post on the potential time bomb for bank capital embedded in IFSR9 but Adrian Docherty has saved me the trouble. He recently released an update on IFRS9 and CECL titled Much Ado About Nothing or Après Moi. Le Deluge?

This post is fairly technical so feel free to stop here if you are not a bank capital nerd. However, if you happen to read someone saying that IFRS 9 solves one of the big problems encountered by banks during the GFC then be very sceptical. Adrian (and I) believe that is very far from the truth. For those not discouraged by the technical warning, please read on.

The short version of Adrian’s note is:

  • The one-off transition impact of the new standard is immaterial and the market has  largely ignored it
  • Market apathy will persist until stressed provisions are observed
  • The dangers of ECL provisioning (procyclical volatility, complexity and subjectivity) have been confirmed by the authorities …
  • … but criticism of IFRS 9 is politically incorrect since the “correct” narrative is that earlier loan loss provisioning fulfils the G20 mandate to address the problem encountered during the GFC
  • Regulatory adaption has been limited to transition rules, which are not a solution. We need a fundamentally revised Basel regime – “Basel V” – in which lifetime ECL provisions somehow offset regulatory capital requirements.

Adrian quotes at length from Bank of England (BoE) commentary on IFRS 9. He notes that their policy intention is that the loss absorbing capacity of the banking system is not impacted by the change in accounting standards but he takes issue with the way that they have chosen to implement this policy approach. He also calls out the problem with the BoE instruction that banks should assume “perfect foresight” in their stress test calculations.

Adrian also offers a very useful deconstruction of what the European Systemic Risk Board had to say in a report they published in July 2017 . He has created a table in which he sets out what the report says on one column and what they mean in another (see page 8 of Adrian’s note).

This extract from Adrian’s note calls into question whether the solution developed is actually what the G20 asked for …

“In official documents, the authorities still cling to the assertion that ECL provisioning is good for financial stability “if soundly implemented” or “if properly applied”. They claim that the new standard “means that provisions for potential credit losses will be made in a timely way”. But what they want is contrarian, anti-cyclical ECL provisioning. This is simply not possible, in part because of human psychology but, more importantly, because the standard requires justifiable projections based on objective, consensual evidence.

Surely the authorities know they are wrong? Their arguments don’t stack up.

They hide behind repeated statements that the G20 instructed them to deliver ECL provisioning, whereas a re-read of the actual instructions clearly shows that a procyclical, subjective and complex regime was not what was asked for.

It just doesn’t add up.”

There is of course no going back at this point, so Adrian (rightly I think) argues that the solution lies in a change to banking regulation to make Basel compatible with ECL provisioning. I will quote Adrian at length here

 “So the real target is to change banking regulation, to make Basel compatible with ECL provisioning. Doing this properly would constitute a genuine “Basel V”. Yes, the markets would still need to grapple with complex and misleading IFRS 9 numbers to assess performance. But if the solvency calculation could somehow adjust properly for ECL provisions, then solvency would be stronger and less volatile.

And, in an existential way, solvency is what really matters – it’s the sina qua non  of a bank. Regulatory solvency drives the ability of a bank to grow the business and distribute capital. Accounting profit matters less than the generation of genuinely surplus solvency capital resources.

Basel V should remove or resolve the double count between lifetime ECL provisions and one-year unexpected loss (UL) capital resources. There are many different ways of doing this, for example:

A. Treat “excess provisions” (the difference between one-year ECL and lifetime ECL for Stage 2 loans) as CET1

B. Incorporate expected future margin as a positive asset, offsetting the impact of expected future credit losses

C. Reduce capital requirements by the amount of “excess provisions” (again, the difference between one-year ECL and lifetime ECL for Stage 2 loans) maybe with a floor at zero

D. Reduce minimum regulatory solvency ratios for banks with ECL provisioning (say, replacing the Basel 8% minimum capital ratio requirement to 4%)

All of these seem unpalatable at first sight! To get the right answer, there is a need to conduct a fundamental rethink. Sadly, there is no evidence that this process has started. The last time that there was good thinking on the nature of capital from Basel was some 17 years ago. It’s worth re-reading old papers to remind oneself of the interaction between expected loss, unexpected loss and income.  The Basel capital construct needs to be rebuilt to take into account the drastically different meaning of the new, post-IFRS 9 accounting equity number.”

Hopefully this post will encourage you to read Adrian’s note and to recognise that IFRS 9 is not the cycle mitigating saviour of banking it is represented to be. The core problem is not so much with IFRS9 itself (though its complexity and subjectivity are issues) but more that bank capital requirements are not constructed in a way that compensates for the inherent cyclicality of the banking industry. The ideas that Adrian has listed above are potentially part of the solution as is revisiting the way that the Counter cyclical Capital Buffer is intended to operate.

From the Outside


Looking under the hood – The IRB formula

This post is irredeemably technical so stop here if that is not your interest. If you need to understand some of the mechanics of the formula used to calculate credit risk weighted assets under the advanced Internal Ratings Based (IRB) approach then the BCBS published a paper in 2005 which offers an explanation:

  • describing the economic foundations
  • as well as the underlying mathematical model and its input parameters.

While a lot has changed as a result of Basel III, the models underlying the calculation of Internal Rating Based Capital (IRB) requirements are still based on the core principles agreed under Basel II that are explained in this BCBS paper.

The notes in the linked page below mostly summarise the July 2005 paper with some emphasis (bolded text) and comments (in italics) that I have added. The paper is a bit technical but worth reading if you want to understand the original thinking behind the Basel II risk weights for credit risk.

I initially found the paper useful for revisiting the foundation assumptions of the IRB framework as background to considering the regulatory treatment of Expected Loss as banks transition to IFRS9. The background on how the RW was initially intended to cover both Expected and Unexpected Loss, but was revised such that capital was only required to cover Unexpected Loss, is especially useful when considering the interaction of loan loss provisioning with capital requirements.

Reading the BCBS paper has also been useful for thinking through a range of related issues including:

  • The rationale for, and impact of, prudential conservatism in setting the risk parameters used in the IRB formula
  • The cyclicality of a risk sensitive capital requirement (and potential for pro cyclicality) and what might be done to mitigate the risk of pro-cyclical impacts on the economy

If you have read this far then my summary of the BCBS paper and my comments /observations can be found here (and thank you).

I am not a credit risk model expert, so the summary of the paper and my comments must be read with that in mind. I did this to help me think through some of the issues with bank capital adequacy. Hopefully others will find the notes useful. If you see something wrong or something you disagree with then let me know.

APRA’s proposed revisions to capital requirements for residential mortgages

… there is a lot to like in what APRA have proposed but also some issues that would benefit from further thought

Many readers will be aware that APRA released a Discussion Paper (DP) last week titled “Revisions to the capital framework for authorised deposit-taking institutions”.   The paper sets out APRA’s proposed changes to ADI capital requirements defined by the Internal Ratings Based Approach (IRB) and Standardised Approach to Credit Risk, Interest Rate Risk in the Banking Book (IRRBB) and Operational Risk. The focus of this post will be the proposals impacting credit risk capital requirements for residential mortgage lending. This post presupposes that the reader is familiar with the detail of what APRA has proposed. For those of you who have not yet got around to reading the whole paper I have added a short summary of the proposals below (see “APRA’s proposals – in more detail”).

My gut reaction is that there is a lot to like in what APRA have proposed but there are also issues that deserve further consideration in order to address the risk of unintended consequence and to better deliver on the objectives of consistency, transparency and competitive neutrality.

Proposals which make sense to me:

  • The increased risk sensitivity of the proposed standardised RWs for residential mortgages is, I believe, a material enhancement of the capital adequacy framework
  • There are arguments (and indeed evidence) for why investor property loans can be as low risk as owner occupier loans (most of the  time) but APRA’s desire to address the systemic tail risk of this form of lending is I think an understandable policy objective for a prudential regulator to pursue
  • Continuing to pursue higher IRB RW via changes to the correlation factor also looks to be a better approach than the 20% floor on LGD currently applied and thankfully also up for revision
  • Applying a higher correlation factor to low PD loans also makes intuitive sense, especially if your primary concern is the systemic risk associated with the residential mortgage lending that dominates the balance sheets of your banking system
  • In addition, the potential for the correlation adjustment to reduce the sensitivity of residential mortgage RWA to the economic cycle (and hence reduce the risk of pro-cyclical stress on capital ratios) is particularly welcome though I believe there is much more to do on this general issue
  • The support for Lender’s Mortgage Insurance (LMI) is also welcome

Areas where I believe the proposed revised capital framework could be improved (or at least benefit from some more thought):

  • The discussion of relative standardised and IRB RW does not address the fact IRB banks are required to hold additional capital to cover any shortfall between loan loss provisions and Regulatory Expected Loss (REL)
  • Residential mortgage portfolios subject to the standardised approach should be subject to a minimum average RW in the same way that IRB portfolios are currently constrained by the 25% floor
  • Applying a fixed scalar to Credit RWA can be problematic as the composition of the loan portfolio continues to evolve

The discussion of comparative IRB and Standardised RW you typically encounter seems to assume that the two approaches are identical in every aspect bar the RW but people working at the coal face know that the nominal RW advantage the IRB banks have has been partly offset by a higher exposure measure the RW are applied to. It appears that APRA’s proposed revisions will partly address this inconsistency by requiring banks using the Standardised Approach to apply a 100% Credit Conversion Factor (CCF) to undrawn loan limits.  IRB banks are also required to take a Common Equity Tier 1 deductions for the shortfall between their loan loss provisions and REL. The proposed revisions do nothing to address this area of inconsistency and in fact the Discussion Paper does not even acknowledge the issue.

Residential mortgage portfolios subject to the standardised approach should be subject to a minimum average RW in the same way that IRB portfolios are constrained. The majority of new residential mortgages are originated at relatively high LVR (most at 70% plus and a significant share at 80% plus), but the average LVR will be much lower as principal is repaid (and even more so if you allow for the appreciation of property values).  The introduction of a 20% RW bucket for standardised banks poses the question whether these banks will have an advantage in targeting the refinancing of seasoned loans with low LVR’s. The IRB banks would seek to retain these customers but they will still be constrained by the 25% average RW mandated by the FSI while the standardised banks face no comparable constraint.

This is unlikely to be an issue in the short term but one of the enduring lessons learned during my time “on the inside” is that banks (not just the big ones) are very good at identifying arbitrages and responding to incentives. It is widely recognised that housing loans have become the largest asset on Australian bank balance sheets (The Royal Commission issued a background paper that cited 42% of assets as at September 2017) but the share was significantly less when I started in banking. There has been a collection of complex drivers at play here (a topic for another post) but the relatively low RW has not harmed the growth of this kind of lending. Consequently, it is dangerous to assume that the status quo will persist if incentives exist to drive a different outcome.

This competitive imbalance could be addressed quite simply if the standardised banks were also subject to a requirement that their average RW was also no lower than 25% (or some alternative floor ratio that adjusted for the differences in exposure and REL noted above).

Another lesson learned “on the inside” is that fixed scalars look simple but are often not. They work fine when the portfolio of assets they are scaling up is stable but will gradually generate a different outcome to what was intended as the composition of the loan book evolves over time. I don’t have an easy solution to this problem but, if you must use them, it helps to recognise the potential for unintended consequence at the start.

Read on below if you have not read the Discussion Paper or want more detail on the revisions APRA has proposed and how these changes are proposed to be reconciled with the FSI recommendation. This is my first real post so feedback would be much appreciated.

Above all, tell me what I am missing … 


Note: The original version of this post published 22 February 2018 stated that inconsistent measurement of the exposures at default between the standardised and IRB approaches  was not addressed by APRA’s proposed revisions. I believe now that the proposed application of a 100% CCF in the Standardised Approach would in fact address one of the areas of inconsistency. The treatment of Regulatory Expected Loss remains an issue however. The post was revised on 24 February to clarify these points.

APRA’s proposals – in more detail

Good quality loans fully secured by mortgages on occupied residential property (either rented or occupied by the borrower) have been assigned concessionary risk weights (RW) ever since risk weighted capital adequacy ratios were introduced under Basel I (1988). The most concessionary risk weight was initially set at 50% and reduced to 35% in the Basel II Standardised Approach (2006).

APRA currently applies the concessionary 35% RW to standard eligible mortgages with Loan Valuation Ratios (LVR) of 80% or better (or up to 90% LVR if covered by Lender’s Mortgage Insurance) while the best case scenario for a non-standard mortgage is a 50% RW. Progressively higher RW (50/75/100) are applied for higher risk residential mortgages.

Under the Standardised Approach, APRA proposes:

  • The classification of a Standard Eligible Mortgage will distinguish between lowest risk “Owner-occupied P&I” and a higher risk “Other residential mortgages” category which is intended to be conceptually similar to the “material dependence” concept employed by Basel III to distinguish loans where repayment depends materially on the cash flows generated by the property securing the loan
  • 6 RW bands for each of these two types of residential mortgage (compared to 5 bands currently)
  • Standard Eligible Mortgages with lower LVR loans to be assigned lower RW but these loans must also meet defined serviceability, marketability and valuation criteria to qualify for the concessionary RW
  • The higher RW applied to “Other residential mortgages” may take the form of a fixed risk-weight schedule (per the indicative RW in Table 3 of the Discussion Paper) but might also be implemented via a multiplier, applied to the RW for owner-occupied P&I loans, which might vary over time “… depending on prevailing prudential or financial stability objectives or concerns”
  • Relatively lower capital requirements to continue to apply where loans are covered by LMI but its preferred approach is to apply a RW loading to loans with LVR in excess of 80% that are not insured (i.e. the indicative RW in Table 3 assume that LMI covers the high LVR loans)
  • Non-Standard residential mortgages should no longer benefit from any RW concession and be assigned a flat 100% RW irrespective of LVR and LMI

While the IRB requirements impacting residential mortgages are largely unchanged under Basel III, APRA proposes the following changes to the Australian IRB Approach to reflect local requirements and conditions:

  • Increased capital requirements for investment and interest-only exposures; to be implemented via a higher correlation factor for these loans
  • The (currently fixed) correlation factor applied to residential mortgages to be amended to depend on probability of default (PD); reflecting empirical evidence that “… the default risk of lower PD exposures is more dependent on the economic cycle  and can consequently increase at a relatively higher rate in a downturn”
  • A reduction in the minimum Loss Given Default (LGD) from 20% to 10% (subject to APRA approval of the LGD model); in order to facilitate “… better alignment of LGD estimates to key drivers of loss such as LVR and LMI”
  • Capital requirements for non-standard mortgages use the standardised approach; increasing consistency between the IRB an standardised approaches

APRA’s proposals seek to strike a balance between risk sensitivity and simplicity but must also take account of the FSI recommendations that ADI capital levels be unquestionably strong while also narrowing the difference between standardised and IRB RWs for residential mortgages. APRA is undertaking a Quantitative Impact Study (QIS) to better understand the impact of its proposals but the DP flagged that APRA does not expect the changes to correlation factors to meet its objectives for increased capital for residential mortgage exposures.

APRA could just further ramp up the correlation factor to generate the target IRB RW (which I assume continues to be 25%) but the DP notes that this would create undesirable inconsistencies with the correlation factors applied to other asset classes. Consequently, the DP indicates that the target increase in IRB RWA will likely be pursued via

  • A fixed multiplier (scalar) applied to total Credit RWA (i.e. althoughBasel III removes the 1.06 Credit RWA scalar, APRA is considering retaining a scalar with a value yet to be determined); and
  • If necessary, by applying additional specific RWA scalars for residential (and commercial) property.

These scalars will be subject to consultation with the industry and APRA has committed to review the 10.5% CET1 benchmark for unquestionably strong capital should the net result of the proposed revisions result in an overall increase in RWA’s relative to current methodologies.