Loophole used by banks to hide property losses to be closed

New accounting rules will force lenders to make provision for souring loans earlier

Thu, Jul 24, 2014, 22:32

The loophole that allowed Irish banks not to disclose their property losses during the crash has finally been closed.

Under new international accounting rules, which will take effect in 2018, banks will be obliged to provision for souring loans much earlier.

The Irish banking meltdown in 2008 on the back of the collapse of Lehman Bros in the US highlighted how little capital banks held to cover a slump in the value of the assets on their books, forcing the public to bail out many lenders.

Amid a welter of regulatory reforms following the crisis, the Group of 20 leading economies (G20) called for a single global accounting rule that would force lenders to make provisions for souring loans much sooner after a loan is made, so banks have time to plug any capital gaps.

The downside is that bank results will become more volatile, given that lenders have habitually delayed taking losses on bad loans partly to smooth their reported profits over time.

A majority of banks surveyed by accountants Deloitte expect their provisioning to rise by up to half, under the rule, known as IFRS 9, published by the International Accounting Standards Board (IASB) today.

The IASB, whose rules are applied in over 100 countries, including Europe but not in the United States, said it was its final reform in response to the 2007-09 crisis.

The rule will require banks to set aside some capital to cover loans on day one, and recognise full lifetime losses on the loan if risks have increased, such as if a repayment is more than 30 days late.

In the run up to the crisis, banks in Ireland and elsewhere only made provisions when a loss had been incurred, typically at the point of default.

Accountants warn the change will lead to banks holding more capital, as well as causing bigger swings in their financial figures.

“The focus on expected losses is likely to result in higher volatility in the amounts charged to profit or loss, especially for financial institutions,” accounting firm EY said.

Banks will have to use far more judgement on the likelihood of losses, which is typically tied to the business cycle.

“Where this really comes into play is where you at the start of economic decline, which is where the current incurred loss model would be slow to respond but the new expected loss one would be quicker to react,” said Andrew Spooner, lead financial instruments partner at Deloitte.

The new rule also scraps the ability of banks who use IASB accounting standards to book a profit on their bonds if they fall in value, reflecting a counterintuitive rationale that they could be bought back more cheaply than previously.

Although the new rules won’t formally come in until January 2018, regulators and investors may put pressure on lenders to move early to allay compliance concerns, Mr Spooner said.

Since the financial crisis, bank supervisors already force lenders to make provisions above the level required under accounting standards and Spooner expects this pressure to top up provisioning to continue even under the new book-keeping rule.

Still, Andrew Bailey, chief executive of Britain’s Prudential Regulation Authority, a banking watchdog, said the reform should improve provisioning so supervisors can focus more on unexpected losses.

“I hope that implementation of the new accounting standard for provisioning ... is a step in this direction,” Mr Bailey said.

The EU will need to endorse the rule for it to be applied in the 28-country bloc, a step that could take some months.

Despite a G20 push, the IASB and its US counterpart, the Financial Accounting Standards Board, failed to agree on a common global provisioning rule. The United States is taking a tougher line with its GAAP accounting rules to force banks to make full provisioning from day one.

“For investors it will be harder to benchmark companies and understand and compare the financial position of IFRS reporters and those applying U.S. GAAP,” said Nigel Sleigh-Johnson, head of faculty at the ICAEW, an international accounting body.

Reuters