Loss Provisioning Turns Into Guesstimates Due To COVID19 Uncertainty

No one knows what COVID19 will do to banks’ or other lenders balance sheets and what effect will the mitigation plans put in place by the governments and regulators have. Economists and other experts can only provide best guesstimates at the moment what shape the recovery post COVID19 may take.

Nonperforming loans are likely to increase post COVID19, but the size of this increase is not predictable for now. Should the economic stress last longer or if the recovery is slower than projected, loan/other financing related losses will be higher. Current expectations of a strong rebound in Europe during the second half of 2020 carried over into the next year, suggest that medium to long term credit losses may be avoided with the current forbearance activity by lending institutions. Again, the expectations and magnitude of the rebound may not be as strong, and the temporary relief now may become a bigger headache later.

The Bank of England said March 26 that ECL estimates should be based on “the most robust, reasonable and supportable assumptions possible in the current environment”. This, among other factors, will help to hold back the risk of a significant overstatement of ECLs that would put unnecessary strain on the balance sheets. The BoE further stated that “any changes made to ECL to estimate the overall impact of COVID-19 will be subject to very high levels of uncertainty as so little reasonable and supportable forward-looking information is currently available on which to base those changes.”

“No forward-looking model could have predicted the features of the COVID-19 medical situation and its implications,” Deloitte risk advisory experts wrote in a March 20 blog post. Clearly, there are more questions than answers.

Absent the capacity of banks/other lenders to anticipate adverse shifts in aggregate conditions sufficiently in advance, the upfront recognition of future expected losses (IFRS9) may paradoxically imply that, right at the beginning of economic contractions, banks/lenders suffer a more abrupt fall in profits and subsequently capital than under the old incurred loss paradigm. Expected loss provisioning can add procyclicality.

The sudden and unexpected nature of the pandemic, and the certainty that its implications will be less damaging for the economy if there is plenty of credit flowing towards the affected businesses and households, suggest the desirability of preventing the procyclical damage that the new provisioning standards can cause in this crisis.

In a recent column advising against any change in current provisioning standards, Nicolas Véron, a French economist, argues “there is no perfect accounting thermometer for credit risk in banks’ loan books, but breaking the current thermometer in the midst of a crisis would do far more harm than good.”

Understood that changing of rules in the middle of the match should be avoided at all costs, however given the nature and severity of the COVID19 crisis and the importance of bank/other institutional credit in coping with it call for and fully justify an alternate plan of catering to the need for adequate loss provisioning i.e. the transitional arrangements. Taking a reserve now based on calculated assumptions would indicate institutional prudence towards future losses. These assumptions can be tweaked and corresponding reserve levels aligned every quarter based on actual data as the global economy moves through different phases. The central banks can play a role in assigning a minimum (but realistic) loss reserve percentage for the lenders and review the reserves against the assumptions over the course of next 2 to 4 quarters. By that time the provisions will be actual data and economic direction driven.

Author’s Note. “The views and opinions expressed in this article are strictly those of the author and do not reflect the official policy or position of any company.”

Originally published on LinkedIn, 9 May 2020.