Interaction between the prudential and
accounting framework – Expected losses

Publication date: 1 July 2016

Key messages:

• The prudential framework has been strengthened since the beginning of the financial crisis resulting in more resilient financial sector. Some of the concerns that instigated the IASB revision of the impairment model have been in the meantime also addressed by prudential measures. The regulators declared not to focus on further significant increase of overall capital requirements.
• The overall amount of provisions under IFRS 9 includes impairment and expectations of future losses (that may or may not materialize). The provision balance will increase on the adoption of IFRS 9 due to incorporation of such future expected losses on a catch-up basis(retrospective application of IFRS 9). This will have a negative impact on shareholders’ equity and CET 1 ratios. What will not change is the overall amount of risk, or losses. A decrease in CET1 ratio without a change in the overall level of expected and unexpected losses is not acceptable.
• Current prudential rules were calibrated on accounting’s Incurred Loss Model. Assuming that the prudential expected loss (EL) is correct from a prudential point of view (12 month-EL), the prudential rules need to be recalibrated to reflect the changes of the new accounting model (Lifetime Credit Expected Losses-LTECL) consistently for STA and IRB approaches. Under the current prudential framework, own funds requirements are determined to absorb unexpected losses and there is potentially an overlap between LTECL determined according to IFRS 9 and unexpected losses as defined by the regulatory framework. The delta between 12 m EL and LTCEL is already reflected in the unexpected losses under prudential framework, covered by capital. The impact on capital ratios resulting from the IFRS 9 should be taken into account in the overall calibration of the capital framework to avoid double counting and ensure a level playing field, regardless of the underlying accounting regime.
• Without adjustments to the current capital regime by 2018, CET1 ratios are expected to decrease without a corresponding change in the level of risk, risk appetite, banks’ strategy, management or level of losses. The increased cost of capital is expected to impact banks’ lending practices and pricing unless the prudential framework is modified to offset the capital impact of IFRS 9 expected loss model.
• A revision is required before 2018. An EU solution must be introduced should the Basel Committee fail to provide a satisfactory solution for 2018.