Compatibility of IFRS and Regulation Dealing with Loan Loss Provisioning

Presentation for the seminar:

CREDIT RISK MANAGEMENT AND REGULATORY PROVISIONING IN AN IFRS ENVIRONMENT

Vienna, October 21, 2014

Regulatory Framework for NPL Recognition and Provisioning – the

Case of Croatia

Run-up to Crisis the Croatian National Bank traditionally applies a

wide array of prudential regulation established through subordinate legislation (“decisions”)signed by the governor; the adherence of banks to the decisions is supervised by the banking supervision departments

prudential regulation is created based on experience with the 1998-2000 crisis, when a significant part of the banking system collapsed or was bailed out through massive and extremely costly government support

that situation created public and political awareness about risks associated with banking operations

in the 2000-2006 period, due to positive market developments and consistent regulation, bank portfolios were mopped up from the crisis impact: NPLs decreased below 5%, and they were provisioned for by 60%

the effects of prudential regulation improved due to active application of macro-prudential measures

Regulatory Framework

the Accounting Act – introduces IFRS as standard accounting practice in Croatia (especially for banks)

the Credit Institutions Act & the Act on the Croatian National Bank – give supervisory and regulatory powers to the CNB

the Decision on the Classification of Placements and Off Balance Sheet Liabilities – creates operational framework for supervision and accounting of credit risk

Basic Accounting & Prudential Framework before 2013

NPL definition: non-collateralised: 90 days past due collateralised: loans which will not be fully recovered,

depending on the estimation of cash flows, but at the latest two years after taking legal actions by activating collateral

provisioning based on IAS 39 modified by: compulsory classification as NPL (with at least minimal provisions)

90 days past due if no legal action was taken 30% compulsory provisioning two years after legal action was

taken to collect the loan for non-collateralised loans prescribed provisioning depending on

past-due time buckets: 90 – 180 days past due, up to 30% 180 – 270 days past due, 30% up to 70% 270 – 365 days past due, 70% up to 100% more than 365 days past due, 100%

the interest on NPLs is recognised only if collected (not based on accrual)

Dynamics of NPL and Provision Coverage 2005-2014

decrease of coverage is the consequence of inflow of fresh, low provisioned NPLs, but also of sometimes quite imaginative and very brave collection plans

on-site examination was used as an auxiliary tool with some success; the majority of coverage increase in 2011 and 2012 was its contribution; active resistance of banks to risk recognition created extremely high workload for both staff and management of the CNB

the lack of standard NPL definition increased the problem, as banks claimed that our NPL definition is stricter than in other jurisdictions, so coverage rates are not comparable

From 2007 until 2010 NPL coverage radically decreased in spite of stable regulation.As coverage stagnated subsequently, in 2012 it became obvious that prudential regulation isn’t getting proper traction.

6,2%5,2% 4,8% 4,9%

7,8%

11,2%12,4%

13,9%

15,7%16,6%

60,3%56,8%

54,4%

48,7%

42,8%

38,8%41,4% 42,6%

46,2%48,0%

20%

25%

30%

35%

40%

45%

50%

55%

60%

65%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

2005 2006 2007 2008 2009 2010 2011 2012 2013 1H2014

NPL ratio and coverage, Croatia

NPL ratio Coverage-right

Comparative Dynamics I

Source: IMF, FSI Tables

2,2% 2,1% 2,4%

6,4%

11,9%

15,0%

16,6%

109,9%100,4%

77,1%

58,2% 61,4% 59,5% 63,0%

20%

40%

60%

80%

100%

120%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

2006 2007 2008 2009 2010 2011 2012

Bulgaria

NPL ratio Coverage-right

4,2%5,8%

8,2%

11,8%

15,2%

18,0%

21,1% 23,3%

36,9%40,6%

45,3% 47,4%

20%

30%

40%

50%

60%

70%

80%

90%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

2008 2009 2010 2011 2012 2013

Slovenia

NPL ratio Coverage-right

6,6%

5,8%6,3%

9,4%10,0%

11,7%

13,7%

15,1%

46,0%

49,4%

46,1%

40,0% 40,3% 40,2% 40,0% 39,6%

20%

30%

40%

50%

60%

70%

80%

0%

2%

4%

6%

8%

10%

12%

14%

16%

2006 2007 2008 2009 2010 2011 2012 2013

Italy

NPL ratio Coverage-right

2,6% 2,3%3,0%

6,7%

9,8%

13,4%

15,8%

17,6%

57,1%

64,8%

43,6%

37,4% 38,9%

46,3%49,1% 47,8%

20%

30%

40%

50%

60%

70%

80%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

2006 2007 2008 2009 2010 2011 2012 2013

Hungary

NPL ratio Coverage-right

Comparative Dynamics II

Source: IMF, FSI Tables

0

20

40

60

80

100

120

2006 2007 2008 2009 2010 2011 2012 2013

%

NPL coverage, Croatia and countries with similar NPL ratio

Ireland Italy Slovenia BulgariaCroatia Hungary Romania

Issues Noted major weaknesses recognized in accounting practices were:

30% provisioning was required two years after taking legal action to collect the loan; to avoid it, banks simply didn’t take legal action (initiate foreclosure)

after 30% provisioning no additional provisioning was compulsory in spite of process duration and complexity

“running two year gap” – cash flow from collateral was always expected two years from now; typical IAS 39 based evaluation was based on the best case scenario; in supervised banks all estimates of time and sale price of real estate collateral proved drastically wrong

in evaluation, the real estate value is average of the following three components: market value, replacement value and present value; market value was based on the last known similar transaction (frequently before 2008)

discontinued projects were evaluated as completed auditors confirmed everything, providing that it could technically

be presented under IFRS framework findings of on-site examinations and shareholders' reactions to

these findings made obvious that the management and the owners jointly pursue a strategy of optimistic valuation and that auditors are ready to support it

Change of Regulation in 2013 amendments to the Decision on the classification of

placements were adopted those amendments made the following changes:

compulsory provisioning was regulated in detail: compulsory 10% provisioning 90 days past due (delinquency), if no collateral was

activated compulsory 20% provisioning one year after delinquency, if adequate collateral

was not activated compulsory 30% provisioning two years after delinquency, regardless of legal

action taken to activate a collateral; after accounting for 30%, each 6 months an additional 5% compulsory

provisioning minimum of 1% provisions was established for NPLs regulation of restructured loans (how to treat them after restructuring, criteria

for their rehabilitation into performing loans) compulsory minimum haircuts and collection periods were introduced for

real estate and movable property consecutive compulsory provisions (10%, 20%, 30%) were aimed at

motivating banks to timely start foreclosure, while the additional 5% provisioning was a kind of “lump sum” correction for all other noticed aberrations from best practice; others are meant to adjust NPL & forbearance definition to the new definition approved by EBA BoS (ITS on supervisory reporting regarding forbearance and non-performing exposures)

Impact of Regulation the introduction of the Decision amendments was

designed to have full accounting impact by end-2013 the consequences were obvious:

the cost of provisioning increased from 4 to 6 billion kuna – roughly for 0,5% of total assets, reaching 89% of operational results

the coverage of NPLs by value adjustments increased from 42,6% to 46,2%

but: the banking system remained overall profitable workout operations and sale of NPLs intensified

banks’ overall and operational results in 1H2014 improved significantly compared with the same period last year in spite of stricter regulation

International Financial Reporting Standards (IFRS) and Prudential

Regulation

IFRS

IFRS offer standardised reporting framework they facilitate transparency of markets and

comparability of different investment opportunities

the optimal allocation of capital depends on proper application of IFRS

The valuation of certain asset classes under IFRS is sensitive to assumptions applied

When Arbitrary decisions influence IFRS reports?

core portfolios, such as performing loans and all positions created through arms length transactions are evaluated based on “pure” IFRS

prudential regulation interferes only with “marginal” high risk portfolios: NPL & problem loans, litigations, regulatory breaches and deviations from good corporate governance

the valuation of such positions is based on subjective judgment about future outcome.

the implementation of prudential standards limits subjective judgment, increasing comparability of banks’ accounts

prudential reports will materially deviate from IFRS reporting only if the bank has a very risky business profile.

Reporting is the responsibility of the management. If they find the regulatory requirements misleading, they should adjust the regulatory reporting through a “statement of differences” for tax and shareholders reporting purposes.

Preconditions for IFRS Effectiveness

the precondition for accurate accounting is an active supervision of management reporting by shareholders motivated to recognize the real value of their assets

in banking, regulation could strongly influence the rational behavior of shareholders, making them more relaxed toward overvaluation of bank’s assets

In certain circumstances rational shareholders would motivate management and auditors to apply optimistic assumptions in valuation of bank’s assets. If so, IFRS loose its major purpose – providing comparable accounts

Shareholders’ Benefits from Optimistic Valuation

if an institution is close to a regulatory minimum, rational shareholders would attempt to fulfill the regulatory requirement with “ghost capital”.

the “ghost capital” created through optimistic valuation would improve regulatory compliance and, due to avoidance of dilution, (modeled in appendix), increase the expected RoE; additionally, it would create immediate material benefits for managers

without regulatory interference, such a strategy is financially superior to prudent accounting

in extreme cases such motivation did create “moral hazard”

without effective regulatory checks an obvious temptation does exist; to increase the robustness of the system, the regulation should establish the minimum required level of prudence

IAS 39 offers the possibility to increase the capital buffer through an optimistic valuation of NPL/problem loans.

Protecting Public Interest

prudent bank accounting protects the key public interest because: banking is a critical infrastructure of the economy

and its robustness depends on proper accounting in several countries banks’ managers recently

acted as “fiscal agents”, effectively ruining or at least hampering the fiscal position

properly acting supervisors/regulators decrease fiscal risks and improve the financial stability

Historically, financial impact of too optimistic banking accounting is obvious and significant, most likely exceeding any potential adverse impact of prudential regulation

Conclusion does prudential regulation distort financial reporting to the level

hampering transparency of financial markets? we argue that, banks’ management, shareholders and auditors have

common incentive to use “income smoothing”, achieved through optimistic discretion within IFRS framework; incentives strengthen if bank approaches the regulatory limits

by limiting such behavior banking regulation improves comparability of accounts

banks’management has tools to rectify the requirements of prudential regulation in reporting to shareholders

prudential regulation is public and transparent, so it can’t distort public information; anyway, if distortion appears, its potential adverse effect is only speculative and obviously smaller than potential effects of improper banking accounting IFRS shouldn’t be a

straightjacket for banking regulation. Their subjective elements open a possibility for the banks to overestimate capital, potentialy creating a significant fiscal impact!

Thank you for your attention!

Appendix

Comparative NPV – Retained EarningsYear 0

Bank has regulatory capital 100 and annual AT profit 10.

Bank has 100 shares.

Discounting factor for calculation of NPV is 5%

All profit goes to retained earnings.

prudent accounting

optimistic accounting

profit AT Equity profit per share NPV profit AT Equity profit per share NPV

0 -50,00 100,00 -0,5000 0 10,00 110,00 0,1000

1 11,00 111,00 0,0550 1 10,00 120,00 0,1000

2 11,22 122,22 0,0561 2 10,20 130,20 0,1020

3 11,44 133,66 0,0572 3 10,40 140,60 0,1040

4 11,67 145,34 0,0584 4 10,61 151,22 0,1061

5 11,91 157,24 0,0595 5 -50,00 101,22 -0,5000

Stock price 1,1907 0,9329 Stock price 2,1620 1,6940

Scenario: Scenario:

In year 0 due to increased risk No recognized risks in year 0

recognized one off provisioning Loss recognized in year 5 and covered from reserves

cost 60 creating loss 50.

Loss is covered from existent

equity.

Capital shortage was covered

through public issuance of shares.

Fresh capital increased profit for 1

Stock price in year 6 is 20 *PPS (profit per share adjusted for one-off items)

Comparative NPV – Dividend PayoutYear 0

Bank has regulatory capital 100 and annual AT profit 10.

Bank has 100 shares.

Discounting factor for calculation of NPV is 5%

All profit goes to dividend.

prudent accounting optimistic accounting

profit AT Equity profit per share dividend NPV profit AT Equity profit per share dividend NPV

0 -50,00 100,00 -0,5000 0,0000 0,0000 0 10,00 100,00 0,1000 0,1000 0,1000

1 11,00 100,00 0,0550 0,5000 0,0524 1 10,00 100,00 0,1000 0,1000 0,0952

2 11,00 100,00 0,0550 0,5000 0,0499 2 10,00 100,00 0,0980 0,1000 0,0889

3 11,00 100,00 0,0550 0,5000 0,0475 3 10,00 100,00 0,0980 0,1000 0,0847

4 11,00 100,00 0,0550 0,5000 0,0452 4 10,00 100,00 0,0980 0,1000 0,0806

5 11,00 100,00 0,0550 0,5000 0,0431 5 -50,00 100,00 -0,5000 -0,5000 -0,3918

0,2381 0,0576

Stock price 1,1000 0,8619 Stock price 2,0000 1,5671

NPV CF 1,1000 NPV CF 1,6247

Scenario: Scenario:

In year 0 due to increased risk No recognized risks in year 0

recognized one off provisioning Loss recognized in year 5 and covered by shareholders

cost 60 creating loss 50.

Loss is covered from existent

equity.

Capital shortage was covered

through public issuance of shares.

Fresh capital increased profit for 1

Stock price in year 6 is 20 *PPS

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