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Non-performing assets (NPAs) are a recurring feature in financial crises. Poor asset quality translates into lower interest income and higher loan loss provisions, eventually leading to a deterioration in banks’ profitability and regulatory capital. Over time, high NPAs can lead to bank failures, ultimately threatening financial stability. This, in turn, has negative consequences for the banking system’s ability to provide financing to the real economy.
The timely identification of NPAs helps to ensure that the stock of problem assets are recognised on bank balance sheets. Applicable accounting standards on loan impairment and regulatory guidance on NPA entry and exit criteria – which are not harmonised across jurisdictions – set the broader context for the NPA identification process. Notwithstanding differences in both accounting and regulatory frameworks, determining whether and when an exposure is considered “non-performing” is not always clear-cut and requires banks and supervisors to exercise judgment, based on a combination of quantitative and qualitative factors that are common features of regulatory NPA identification regimes.
Effective NPA measurement practices increase the likelihood that NPAs are appropriately recognised in bank earnings and regulatory capital. The financial implications of NPAs boil down to determining whether and, if so, how much provisions are needed to write down the carrying value of an NPA to its estimated recoverable amount. Provisioning outcomes are heavily influenced by whether jurisdictions are bound by accounting standards, regulatory provisioning guidance or a combination of the two to recognise provisions through the profit and loss (P&L) statement. The various supervisory approaches used to deal with the treatment of accruing interest income on an NPA and loan write-off criteria, among others, also influence how NPAs impact earnings and regulatory capital.
Once a loan is placed on NPA status, the single biggest driver of the required level of provisions is the value assigned to collateral, which is a heavily assumption-dependent process. While international accounting standards do not prescribe valuation approaches, they require banks to value collateral based on the net present value (NPV) method; that is, to consider the time and costs required to acquire and sell collateral. The assumptions that underpin the NPV approach are particularly important in jurisdictions where the legal framework results in long delays for creditors to gain collateral access. Some jurisdictions impose regulatory prescribed haircuts on appraised collateral values supporting an NPA. These two valuation methods differ and can lead to vastly different provisioning outcomes.
This paper focuses on the role that prudential regulation and supervision can play in facilitating the prompt identification and measurement of NPAs, by taking stock of cross-country practices. The FSI stock-take covered prudential requirements and their interaction with locally applicable accounting standards. Select Asian, Latin American and Caribbean countries, as well as the United States and European countries were included in the study.
The findings reveal considerable differences across jurisdictions in applicable accounting standards, which are exacerbated by divergent prudential frameworks that govern NPA identification and measurement. These differences make it difficult to make meaningful comparisons both within and across jurisdictions on key asset quality metrics, which are often a driver of a bank’s overall financial condition and operating performance.
Recently published guidelines by the Basel Committee on Banking Supervision (BCBS) provide an opportunity for supervisory authorities to harmonise NPA identification frameworks. In April 2017, the BCBS published its guidance on prudential treatment of problem assets (PTA), which provides harmonised definitions for “non-performing” and “forborne” exposures, including entry and exit criteria (BCBS (2017)).
There is no comparable internationally harmonised framework that governs NPA measurement. In this context, the FSI stock-take reviews a variety of prudential approaches used in different countries. A number of these practices may provide useful insights for prudential authorities.
Against this background, a range of regulatory and supervisory policy options can be considered, if applicable, to improve existing practices for the identification and measurement of NPAs