Reality versus stability: The role of dynamic provisioning

Accounting standard setters are under growing pressure from
prudential regulators to change the rules on provisions for losses in financial
institutions, as part of the bid to prevent a repeat of the financial meltdown.
The issue is the subject of heated debate at the Financial Crisis Advisory
Group, the high-level gathering set up by the international and the American
accounting standards boards, IASB and FASB respectively, to deal with reporting
issues arising from the global banking disaster.

Standard setters are wrestling with the issue of whether general purpose
financial statement can include the sort of ‘through-the-cycle’ or ‘dynamic’
provisioning that may be demanded by prudential financial services regulators
without diminishing the transparency of information to investors.

Provisioning models
IASB chairman Sir David Tweedie told the group meeting in New York in March that
there were four provisioning models:

• The current IFRS standard is based on incurred losses; there is also
• Expected provisioning;
• Dynamic provision; and
• Fair value provisioning.

The group does seem to accept that the current impaired loss model is broken
because it recognises bank losses too late in the cycle. Standard setters
applaud the idea of enhanced transparency in loans provision, but don’t
necessarily equate that to a move towards a dynamic model.

The standard setters are also determined that financial regulators shouldn’t
dump their problems onto financial reporting. Apart from that, there seems
little consensus among standard setters on the way forward. The original idea
that the issue could be put to bed as early as May now seems unlikely.

Under historic cost accounting, provisions are made for losses recognised at
the balance sheet date. For instance, in relation to specific provisions the UK
statement of recommended practice says, “A loan is impaired when, based on
current information and events, the bank considers that the creditworthiness of
a borrower has undergone a deterioration such that it no longer expects to
recover the advance in full.”

The accounting approach differs from the banks’ implicit attitude to lending
as they expect a proportion of their loan portfolios will be lost each year.
These are ‘expected losses’ and may differ from the actual losses.

Expected loss
In contrast, the fundamental principle underpinning dynamic provisioning is
that provisions are set against loans outstanding in each accounting time period
in line with an estimate of long-run, expected loss.

According to the Bank of England, in general, the level of provisioning on
this basis would be less subject to sharp swings in strength or weakness of
economic activity than the current approach. Loan losses would hit on banks’
profit and loss accounts and balance sheets more smoothly than at present,
because of the use of expected, rather than actual, losses.

Standard setters have always reacted adversely to the idea of smoothing and
while there is support for the idea of through-the-cycle provisioning for banks
and other financial institutions, they will only accept the practice as long as
it does not detract from the integrity of financial statements. Ideas put
forward to overcome objections include economic cycle reserves ­ basically,
building up a buffer in the good times that can be released in the lean years.

So standard setters want to contribute to sorting out the current mess, but
they are telling the world’s regulators that their role is to produce standards
which require companies to reflect economic reality, not support financial
stability.