Where Lord Mandelson, Lord Turner and Gordon Brown have gone, Sir David
Tweedie now follows. Banks are being told by Sir David’s International
Accounting Standards Board (IASB) that new, complex, expensive structures are
needed to stop them making money in the boom, at the expense of a bust.
Philosophically, there’s much common ground between standard setters and the
banks. Indeed, all sides seem to agree the rules reflect responsible and prudent
But look beneath the veneer of the IASB’s model and the disagreement begins.
Under current regulatory rules, known as Basel II, banks have to forecast one
year in advance for loan losses. Under the IASB’s proposal banks would have to
do the same for each year of the loan’s life. In the case of an average UK
mortgage, 25 years.
This means on the day the bank signs the loan, it will also have to record
the expected loss for every year of the loan’s life. Experts suggest that, while
this may be possible during the first few years, beyond this banks enter the
realm of fortune-telling.
“The judgments involved in predicting expected losses will be hugely
subjective,” said Colin Martin, KPMG head of assurance services.
Of course, banks estimate credit risks everyday, but not in the sort of detail
assumed by the proposals. The bank would have to revisit loans at least once
each year, perhaps quarterly and reset their expected cash flows for each year
of the loan’s life.
Which brings banks to their next big gripe – the level of granularity. French
bank BNP Paribas estimated 5,000 loan pools would need to be divided into about
200,000 if split by risk, period of origination and period of maturity. A case
study of one small, regional bank found it alone had 300 different product
Another concern is that the provisions do not reflect reality. In a situation
where a customer loses their job, for example, the bank’s expectation of the
loan being repaid would change, and so too would its expected cash flow from
that loan. The fact that the customer may continue to pay the loan is
The IASB’s proposals rely on expectations, and expectations can change
whether or not a payment is ever missed.
Under the current rules banks only record a loss when there is a trigger – an
observable event which suggests a loan will not be repaid, like a payment
default. However, this allowed banks to record future cash flows from the loan
up until a trigger occurred, ignoring all other factors. The result was that
banks recorded profits from loans they knew would in all probability turn bad.
Worrying regulators is the possibility that the overall effect would
exacerbate the boom and bust cycle. When economic times are good, loss
expectations will be low. When a downturn arrives, loss expectations will rise
These loss expectations will feed into profit figures, which means banks may
go into the red due to expected unrealised losses.
The IASB is consulting on the matter and has assembled a panel of credit risk
experts rather than technical accountants for feedback. “The challenges of
applying an expected loss approach should not be underestimated… for this reason
the IASB will tread carefully” Sir David said when releasing the proposals in
November. The consultation ends on 30 June.
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