04 July 2013

EBA: Response to IASB on financial instruments (Expected Credit Losses)

The EBA welcomes the efforts of the IASB to improve financial reporting in the area of financial instruments as requested by the G20 and in this regard supports the introduction of an expected loss model. The current incurred loss model has resulted in the well-known “too little too late” recognition of credit losses. The move to an expected loss model will improve the decision usefulness and relevance of financial reporting for users, including prudential regulators.

The EBA supports a model that differentiates between the different stages of credit deterioration during the life of the financial instrument. This model also incorporates a broader range of credit risk information and it reflects banks´ credit risk management.

The EBA acknowledges the efforts of the IASB during the past years to develop a model which takes into account the evolution of the credit quality of financial assets and the EBA recognises the difficulties to strike the right balance between faithfully representing the underlying economics of financial instruments and having a model that is operationally workable. In this context, the EBA recognises the merits of this model and see that it achieves a good compromise.

As prudential supervisors the EBA would be concerned if provisions are not built appropriately to withstand the expected losses that will materialise in future periods and therefore it is necessary that there is an adequate level of provisions for loans and other financial instruments at each stage of the model depending on their credit quality.

In relation to stage 1, the EBA believes that the IASB should provide additional guidance on the meaning of “default” (or another suitable term) as this will help achieving consistent application among entities. The definition could be broadened to encompass a wide range of loss events and not only “technical defaults”.

The definition of and provisioning for stage 1 is particularly relevant for financial assets that have early loss patterns and it is important that the model proposed provides an appropriate level of provisioning in these situations. The EBA understands that there are various possible options for addressing this, including the use of a broader definition of default, or through amendments in stage 1 / stage 2 transfer criteria that would result in such loans being classified in stage 2 either at original recognition or earlier than would be the case under the Exposure Draft’s proposals. The EBA asks the IASB to consider these options further.

In addition, the EBA believes that financial assets should be transferred on a timely basis from stage 1 to stage 2 to reflect their deterioration in credit risk.

The EBA has also some concerns about the low credit risk exception as it departs from the principle-based approach of the model and could eventually result in a delayed transfer to stage 2.

Regarding convergence, the EBA notes that many stakeholders have highlighted the importance of having one single impairment model. The EBA concurs with this view and its preference would be to have a converged model. However, the EBA supports a model that reflects the different stages of deterioration of financial instruments, such as is the intention in the IASB model. The EBA believes that some of its comments could help reduce the differences between the IASB and FASB models. In any case, the EBA thinks that the IASB should finalise the impairment project swiftly as entities will need some time for its implementation and the EBA would not consider it appropriate for this Standard to be further delayed.

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