New Rule Gives Banks Discretion on Early Loan Write-Downs, but Attracts Skeptics

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Hans Hoogervorst, chairman of the International Accounting Standards Board.Credit Christinne Muschi/Reuters

A new accounting rule will give banks much more leeway to write down the value of loans, something that both regulators and bankers demanded in the wake of the financial crisis. Yet the rule could also make it less attractive for banks to make loans in the first place because every loan will lead to an immediate reported loss.

The rule, which was completed on Thursday, was issued by the International Accounting Standards Board, whose standards are used by companies in more than 100 countries but not in the United States. It reverses accounting rules adopted decades ago, when the fear was that banks were using their discretion over reported loan values to manage their earnings.

A similar, but not identical, rule is expected to be issued later this year by the Financial Accounting Standards Board, which sets accounting rules in the United States. The differences between the two rules emerged during deliberations in 2012, causing a bitter split between the two boards.

“The new standard will enhance investor confidence in banks’ balance sheets and the financial system as a whole,” said Hans Hoogervorst, the chairman of the international board. He said the changes in the rule from previous practice provided “much needed improvements in the reporting of financial instruments” and were consistent with changes recommended by the leaders of the Group of 20 countries, who called for “a forward-looking approach to loan-loss provisioning.”

Under the old rules, which were first issued in the United States and then formed the basis for international rules, banks were supposed to take losses on loans only after it was clear that losses truly existed and could be estimated. The rules had been interpreted strictly because of concerns that some banks would deliberately estimate large loan losses in good times, creating what were called “cookie jar reserves” that could then be used in bad times to smooth reported earnings and obscure losses that were really taking place.

“We are moving back to a set of standards where there is more discretion, more judgment,” said Nigel Sleigh-Johnson, an official of ICAEW — formerly called the Institute of Chartered Accountants in England and Wales. “You have to anticipate the future.”

As a result, he said, “there is more room for management judgment, and potentially for earnings management.”

But he said that while “it is not an ideal outcome, most people would agree that moving to an expected loss model is a good thing.” It will allow banks to write down the value of loans when they have reason to expect losses will materialize, rather than wait until the losses are actually incurred.

Officials hope that required disclosures will make it easier for investors to judge whether the banks made appropriate estimates.

Although the international board said its new rule would become effective in 2018, that date could be delayed in some countries while local officials decide whether to endorse the entire standard or perhaps only parts of it.

The logic of reporting an immediate loss when a loan is made is that bankers expect some loans will go bad. If a bank estimates, based on current economic conditions and past experience, that 5 percent of a certain type of loan will not be repaid, at least part of that expected loss is to be reported immediately when the loan is made.

Under the international rule, that loss will be limited to the expected level of losses in the first 12 months the loan is outstanding. Later, further losses would be taken if adverse developments — either in the economy or in particular loans — indicate losses will be greater.

Under the expected American rules, at the outset of a loan the bank will take losses equal to the total expected capital loss during the life of the loan. The expected loss would then be raised or lowered in later years based on changing conditions, causing changes in reported profits.

Either way, a bank that makes a loan on Dec. 31 would end up reporting slightly lower profits for that year than it would have reported had it not made the loan. Conceivably that could cause a bank worried about its reported profits to delay making loans.

Critics of the international board’s approach say it could lead to “cliff effect” reported losses, in which many loans are written down as soon as conditions worsen even though the newly expected losses were expected to happen at some later point. Critics of the United States approach say it will overstate losses when the loan is issued.

In a related action, the international board announced a change to a rule that many investors viewed as perverse during and after the financial crisis. Currently, under some circumstances a bank is supposed to mark the value of some of its own debts at fair value. So a deterioration in a bank’s credit quality causes its reported profits to rise. Conversely, reported profits will decline if the bank appears to strengthen, making its outstanding bonds worth more.

Under the new rule, which will be effective as soon as various countries ratify it, such gains and losses in debt values will still be reported on the balance sheet, but will not show up in net income.

The United States board is expected to adopt a similar proposal.