New accounting rules could cripple parts of the banking sector by forcing earlier recognition of loan losses, as the coronavirus pandemic threatens to push the world into recession.
“There is a problem with the new accounting rules,” which would “increase provisioning in a dramatic way”, one member of the European Central Bank’s governing council told the Financial Times, referring to sweeping changes to the way loans are accounted for.
The adoption of Europe-led accounting standard IFRS 9 has a “procyclical effect”, the person warned, which would make banks more susceptible to the highs and lows of economic cycles.
IFRS 9 requires banks to take earlier provisions for loans going bad, especially when they cross key thresholds such as a “material change in circumstances”. This forces banks to take provisions for the entire lifetime of a loan.
Meanwhile, US banks have been operating under a new standard, dubbed “current expected credit losses”, since the start of the year. This requires them to book lifetime loan losses as soon as there is reason to believe a loan will not be repaid in full.
The old method for both jurisdictions was to book provisions only when customers actually missed payments.
IFRS 9, I hate it as a rule, but relaxing accounting standards in a crisis just doesn’t look right
European banking executive
“If we were still under an ‘incurred loss model’ many companies could likely overlook the current economic issues as long as the creditors are currently paying on time,” said Janet Pegg, an analyst at Zion Research Group, of the situation in the US.
Despite multiple pledges of capital relief for the banking system, stock markets continued to sell off on Monday as the eurozone shut its borders, airlines cancelled tens of thousands of flights and factories announced closures.
An index of European and UK banks has fallen 44 per cent in the past month to a level last seen in the 1990s. The four biggest US lenders by assets plunged a fifth on Monday morning.
Some bank executives said they are concerned that higher loan-loss provisions will absorb much of the capital relief announced by central banks, leaving little left over to be lent on to companies seeking new emergency credit lines.
“We don’t have hard estimates yet for the impact but IFRS 9 will become a real pain for banks,” said one bank executive.
UBS’s Jason Napier said the fallout from coronavirus was “the first real test” of IFRS 9 since it was introduced in 2018.
Kian Abouhossein, an analyst at JPMorgan, said the change in approach meant about 50 per cent of total loan losses would come in the first year, whereas historically 60 per cent of loan losses were spread over the first two years.
Signs of a backlash against the rules already exist. The Association of German Banks has started lobbying for a “more flexible handling” of risk provisions under IFRS 9, and has warned that the existing accounting rules could “massively amplify” the looming crisis. Under the current regime, German lenders would be exposed to “excessive risk provisions and capital needs”, it said.
Jérôme Legras, head of research at Axiom Alternative Investments, said the ECB had done a “good job” with its relief and stimulus package last week, but “it’s only halfway there”.
“They need to talk about the loans,” he said. “Someone needs to say in a very clear way ‘we are not doing IFRS 9 for the next year or so’.”
However, JPMorgan’s Mr Abouhossein cautioned: “To make accounting rules suddenly flexible for certain periods reduces the confidence in the system.”
Felix Hufeld, head of Germany’s banking watchdog BaFin, on Monday said European regulators did not think the present situation merited the softening of regulatory requirements. However, he said watchdogs would act “in a highly flexible way”, in particular with regard to capital requirements.
One European banking executive said, “IFRS 9, I hate it as a rule, but relaxing accounting standards in a crisis just doesn’t look right.”
The difference in accounting approach is likely to be particularly pronounced in the energy sector, which is reeling from a slump in the oil price that could result in a spate of loan losses, said Megan Fox, an analyst at Moody’s.
Ms Fox added that many banks had hedged this exposure, meaning that actual defaults come much later. Under the old regime, loan-loss provisions would have been pushed out for a significant amount of time.
Research from KBW showed Citigroup had the biggest oil and gas exposure of the US banks, with $22.48bn of outstanding loans — equal to 3.2 per cent of its loan book. Bank of America’s oil and gas loans are 1.7 per cent of total loans; and Wells Fargo’s and JPMorgan’s loans to the sector amount to 1.4 per cent of outstanding lending.