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The European banks are supportive of an approach which differentiates between performing assets and those that are no longer performing or that have suffered credit deterioration that is both not reflective of the initial credit risk and relevant for the life time expected loss measurement. Such an approach would help to ensure that impairment allowances are meaningful for different portfolios in different jurisdictions, compared to an approach which is only based on the level of expected losses which would be likely to prejudice higher risk products, businesses and regions.
The IASB model is therefore a step in the right direction, but needs to be both clarified, simplified to make it operational without undue cost as well as to increase its understandability and therefore the likelihood of its acceptance.
The definition of the criteria for moving from 12 months’ to lifetime expected losses is one of the most sensitive elements of the IASB model. This definition is likely to be the key driver of the level of impairment allowances recognied and, if it is not clear, could drive significant inconsistency in practice. It also forms the conceptual basis for the model and therefore it is essential that the objective of the criteria is clearly explained.
The threshold for lifetime measurement should be the point at which the probability of default reaches an absolute level that is relevant from a credit risk management perspective for the particular portfolio. While the principle applied to all portfolios would be the same, the level would be different for different types of loans and portfolios. Consideration must be given to the nature of each portfolio, its maturity, its credit risk characteristics and its geographical location to ensure that the threshold is meaningful for a given portfolio.
The EBF understands that the 12 month measurement basis was introduced as a practical expedient despite the fact that the approach is in conflict with the revenue recognition principle as well as with the measurement of assets at fair value where no D1 loss is recognised. The 12 months could be seen as a proxy for a yield adjustment, although conceptually it is hard to justify 12 months. The provisions for such loans are seen mainly as a buffer because normally the majority of those loans will never default. A 12-month allowance is therefore seen from an economic perspective as more than sufficient to cover the associated risk. Clarification to the mechanism should be given to ensure that the provisions accumulated on loans that are subject to 12 month EL measurement on a portfolio basis will be effectively used to cover losses on those loans that will be transferred for the life time expected losses measurement.
Using 1 year PD for transfer determination would lead to further operational simplification. While some adjustments should be made, PD 1 year is already used for Basel purposes. It is therefore believed that such approach would increase understandability and comparability.
Without modification of the IASB’s model, there is a risk that the FASB model, which lacks a conceptual basis, could be seen as superior mainly given its apparent operational simplicity. The model ignores the link to interest rate recognition leading to full day one loss and the financial reporting would reflect only the dynamic of volumes in the loan portfolios (i.e. additional provisions for new loan originations), obscuring the information about credit deterioration and risk management. Such a model would not meet the objectives of financial reporting.
The European banks are also concerned that the FASB model, if adopted globally, would distort a level playing field given the shorter average maturity of loan portfolios in the US as well as the securitisation practices resulting in derecognition of loans shortly after origination. The impact on the retail business in some European countries could be significant and it is also expected that in these countries lending would become more expensive or the business lending structure would be forced to change, resulting in shortening the maturities of the loans.