22 April 2016

Bank of England: Non-performing loans: regulatory and accounting treatments of assets

Asset quality is difficult for banking regulators and investors to assess in the absence of a common, cross-border scheme to classify assets. This paper documents divergences in the definition of NPLs across countries, accounting regimes, firms and data sources.

The  current  Eurozone  crisis  is  a  stark  reminder  of  the  dangers  posed  to  economic  and financial   stability   by   over-indebtedness,   under-provisioning   and   NPLs.   But   as   authors   have documented,  the  NPL  situation  facing  Europe  today  is  not  unprecedented.  Indeed  it  bears  more than a passing resemblance to past crises in, inter alia, Latin America in the 1980s and Japan in the  1990s  where  protracted  debt  crises resulted  in  ‘lost  decades’.

Ultimately  it  is  poor  lending,  rather  than  accounting  or  reporting,  that  causes  financial crises.  However,  the  timely  recognition  of  problem  loans  and  credit  loss  by  banks,  and  proper transparency  such  that  asset  positions  are  well-understood  by  the  market,  regulators  and  others,

is  critical  in  assessing  how  to  avert  or  mitigate  crises.  As  they  have  seen,  banks  can  be incentivised by accounting, regulatory and tax considerations in various ways when considering how  to  identify,  and   provide  against,  problem  loans.   This  in  turn  can  result  in  under-provisioning,  particularly  when  the  economic  environment  is  relatively  benign.  But the early recognition of expected losses in good times is generally agreed by policymakers to contribute to greater bank resilience and mitigate the impact of crises on banks’ balance sheets. This in turn lowers  the  probability  of  downturns  resulting  in  debt  crises  that  last  several  years  or  even decades.

But  even  before  considerations  of  provisioning,  problem  loans  need  to  be  identified according to criteria that are transparent, understandable and economically meaningful, and there is  currently  no  universal  consensus  as  to  what  these  criteria  should  be.  The  introduction  of expected  loss  provisioning  methodologies  that  require  loans  to  be  classified  into  different categories   adds   further   to   the   need   for   more   understandable   methods   of   asset   quality classification,  in  order  to  provide  adequate  context  for  these  provisions  to  be  understood. Understanding the nature and quality of bank assets remains the key to assessing the health of the banking system as a whole, and transparency in this area is therefore key to financial stability.

Full working paper

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