Expected credit loss approaches in Europe and the United States: differences from a financial stability perspective

Expected credit loss approaches in Europe and the United States: differences from a financial stability perspective

January 2019

Contents

Executive summary 2

1 Introduction 5

2 Understanding the differences between the expected credit loss

approaches in Europe and the United States 6

2.1 Qualitative description of the main differences 6

2.2 Motivation for the different approaches by the IASB and the FASB 9

2.3 Summary of related literature 13

3 Financial stability considerations 16

References 21

Imprint and acknowlegements 23

Contents 1

Executive summary

In the aftermath of the global financial crisis, the leaders of the G20 urged accounting standard setters to reconsider the incurred loss model by analysing alternative approaches to recognising and measuring loan losses that incorporate a broader range of available credit information. In response to that request, accounting standard setters began developing expected credit loss (ECL) models which take account of a broad set of credit and macroeconomic information and have a more forward-looking nature. As a result of that work, the International Accounting Standards Board (IASB) issued International Financial Reporting Standard 9 (IFRS 9) in July 2014, which introduces an ECL approach, while the Financial Accounting Standards Board (FASB) issued Accounting Standards Codification (ASC) 326, which introduces the current expected credit loss (CECL) approach, in June 2016.

The ECL and CECL approaches1 differ in several respects. The main difference is the fact that while the CECL approach mandates the calculation of lifetime expected credit losses for all financial assets under its scope since their inception, the ECL approach in IFRS 9 introduces a dual credit loss measurement approach whereby the loss allowance is measured at an amount equal to either the 12-month expected credit losses2 for those financial assets classified in stage 1 or the lifetime expected credit losses for those assets classified in stages 2 (financial assets with a "significant increase in credit risk") and 3 ("impaired financial assets"). Among the many other differences, it is worth referring to the consideration of financial assets at fair value through other comprehensive income (excluded in CECL) and to the treatment of loan commitments (more prudent in ECL).

When it comes to accounting for expected credit losses, one of the key aspects is the fact that the price of a loan when it is granted should already reflect the credit risk of the borrower at that moment, assuming the loan is adequately priced. Consequently, introducing compulsory loss allowances at the time of the loan's inception could lead to a form of "double-counting" of expected credit losses. While the existence of such double-counting explains, at least partially, the decision of the IASB to define three stages in the ECL approach, public documentation suggests that the FASB may have considered other arguments when defining its CECL approach (Financial Accounting Standards Board, 2012 and 2016; American Bankers Association, 2013). First, a single-measurement approach to the calculation of expected credit losses throughout the life of a loan may have been considered easier to implement from an operational perspective, particularly for smaller and less sophisticated institutions. Second, the FASB has a long tradition of adopting a prudential approach in some of its accounting standards, and that has already been internalised by users and preparers of financial statements in the United States. Finally, the FASB's decision to require lifetime expected losses on loan recognition (and, as a result, the more accurate measurement of the total amount of expected credit losses) could have been influenced indirectly by the moral hazard revealed by the global financial crisis, which was associated with the originate-to-distribute business model that was pursued by a number of US banks.

• 1 The approaches set out in IFRS 9 and ASC 326 are both ECL in nature. However, for ease of reference, the approach set out in IFRS 9 will be referred to as "ECL", whereas the term "CECL" will be used to refer to the approach set out in

  ASC 326.

• 2 Intended as the credit losses that are expected to arise from default events in the following 12 months.

The purpose of this report is not to discuss the relative merits of IFRS 9 and ASC 326, nor to rank the two approaches or question the adoption of IFRS 9 in the EU. The objective of this report is instead to raise awareness of the potential consequences, from a financial stability perspective, of the fundamental differences between them, given that this could affect the way that banks provide credit to the real economy, manage their credit risk and compete in global markets, with the potential to bring about unintended consequences. With that in mind, the following considerations should be noted:

• • Before considering financial stability as such, it is worth noting that the IASB and the FASB have differing views as regards the conceptual basis for accounting for credit losses, as well as the importance to be attributed to the practical implementation of accounting standards. In this sense, it could be argued that the ECL approach in IFRS 9 more accurately reflects the evolution of credit risk, limiting the double-counting of expected credit losses already priced in at the time of the initial recognition of a loan. The CECL approach, on the other hand, could be regarded as facilitating practical implementation by reporting entities, even if that increases the double-counting of expected credit losses at the time of loans' inception.

• • In terms of cyclical behaviour, the limited literature available - including industry studies and academic studies such as Abad and Suárez (2017) and Krüger et al. (2018) - seems to show that the CECL approach may lead to higher impairment charges in normal times, while the ECL approach would have a larger impact at the time of the onset of a crisis (to the extent that the downturn is not anticipated well in advance). Consequently, lending to the real economy over a full cycle in those market segments where US and European banks compete directly may be affected by the differences between the expected impairment charges required by the ECL and CECL approaches. Under the ECL approach, lending in normal times could be less constrained by expected impairment charges - a fact which, if coupled with poor risk management practices, could incentivise lending to less sound borrowers. In a crisis, the impairment requirements in the CECL approach could again make new lending more costly than under the ECL approach (even for the soundest of borrowers); on the other hand, the impact of impairment charges on existing loans would be lower under the CECL approach than it would be under the ECL approach owing to the effect of migrating from stage 1 to stage 2 in the latter.

• • Third, differences between the ECL and CECL approaches could also reflect differences between the EU and the United States in terms of banks' business models and sources of financing for the real economy. In this regard, while the application of a lifetime expected credit loss approach to European banks could in principle be regarded as sounder, proper consideration should be given to its potential implications for the real economy in the long term, given the decisive role that bank lending plays for households and non-financial corporations in Europe.

• • A further consideration relates to the impact of those two different expected credit loss approaches in market segments where US and European banks compete directly (such as lending to large corporations and, to a lesser extent, investment banking). In principle, the analysis of the cyclical behaviour of the two approaches would tend to signal a relative advantage for EU banks, since they would face lower impairment requirements from their lending in good times (see, for example, McKinsey, 2017). Consequently, the lending conditions offered by banks may be different under the two approaches in order to better

reflect the expected evolution of impairment charges over the cycle: both the pricing and the volume of lending may be susceptible to change on these grounds. The extent of these theoretical effects will depend on the level of competition in the relevant market segment, on the market power of ECL and CECL adopters separately, and on individual banks' reactions to moves by direct competitors (whether they have scope, for example, to reduce the price of lending if other banks do so).

A more timely recognition of credit losses, combined with envisaged improvements to banks' credit risk management, is expected to make a significant contribution to financial stability. In practice, nonetheless, this assumption largely depends on the extent to which models can anticipate downturns and the borrowers which will be more severely affected by them (in line with the findings of Grünberger, 2012), which in turn generates modelling risk. In this regard, back-testing of models, even if not explicitly required by the standards, can be a powerful way of assessing and improving their predictive power. Furthermore, in the case of the ECL approach, the application of the concept of a "significant increase in credit risk" is important to ensure that the financial stability benefits of the expected credit loss approach are effectively reaped. Given a range of possible definitions for a "significant increase in credit risk", higher (i.e. less conservative) thresholds would lead to lower impairment charges in normal times and, as a result, higher charges in anticipation of downturns. Consequently, excessively high thresholds could hamper the early recognition of credit losses (which is something that IFRS 9 attempts to achieve). In contrast, lower (i.e. more conservative) thresholds could result in double-counting of expected credit losses that are already reflected in the fair value of the loan at the time of its inception, with possible side effects on the availability of credit and banks' profitability. It is therefore important that banks use appropriate criteria in determining that threshold in order to ensure a timely determination as to whether there has been a significant increase in credit risk following the initial recognition of a loan and, more generally, ensure that banks are able to properly adjust to the existing macroeconomic conditions at any time, strengthening financial stability.

Keywords: expected credit losses, financial stability, IFRS 9, CECL, procyclicality.

JEL codes: G21, M41, G28.