Why can banks not cushion crises?

As the default risk accumulates in an economy, banks should accumulate default risk premiums within capital cushions without incorporating into profit.

Both accounting and capital regimes allow banks to distribute default risk premiums as profit to their shareholders due to a low nonperforming loan ratio in boom times.

The underlying reason of meagre cushions is their inability to secure default risk premiums charged from loans.

Banks release default risk premiums of matured credits. A countercyclical provisioning regime would never allow default risk premiums to be incorporated into profit.

Countercyclicality and procyclicality

The output deviates within business cycles. Each cycle is composed of a bust and boom period. In boom times, risky borrowers can access cheap lending. Growing personal incomes enable highly leveraged borrowers to serve their debt. Borrowers hence need to allocate a smaller portion of their income to serve debt in the following years. Lower delinquencies encourage banks to extend loans to riskier borrowers.

The default risk of loans is massively materialized in bust times when output falls. Borrowers, who lose their jobs or shutdown their businesses, cannot serve their credit installments. When banks are not cushioned with ample capital, they prioritize securing their capital via shrinking loans. Credit rationing further dampens spending. Procyclical capital structures thus exacerbate recessions.

For a robust banking system, countercyclical capital and provisioning regimes are required. Requiring banks to build up their loss absorption cushions during boom times would unwind contractionary pressures in bust times. Robust banks can countercyclically operate in recessions. They can tolerate the nonperforming loans by extending credit terms, deferring credit installments or restructuring credits. Borrowers can raise spending via additional borrowing. A credit expansion during a recession help the economy recover by boosting output and spending.

Profits of good times are losses of bust times

Banks cannot show resilience against crises. Their equities easily melt across surging delinquencies. Both accounting and macroprudential practices aim at a robust banking system via building loss absorbing cushions. The underlying reason of meagre cushions is their inability to secure default risk premiums charged from loans. Both accounting and capital regimes allow banks to distribute default risk premiums as profit to their shareholders due to a low nonperforming loan ratio in boom times. Bank profits in boom times comprises the cushion which will absorb losses in bust times.

Procyclicality of provisioning

Imagine an insurance company that transfers the entire insurance premium into profit when a car does not involve in any accident. Such an accounting practice would collapse the insurance system. Each insurance company reserves a portion of the insurance regardless materialization of risks. Certain types of risks, such as an earthquake, arise once in decades. To absorb those risks, insurance companies constantly accumulate a portion of insurance premiums.

Recessions resembles earthquakes. They arise once in a decade. On the way to the crisis, banks collect default risk premiums from each loan as a part of the interest gain. An optimal provisioning regime would require banks to provision as they collect the interest of loans. Thus, a bank would provision as much as the default risk premium inherited to the interest. In return, it would build a loss allowance cushion for future losses. Thus, default losses would be offset by the allowance cushion. Bank profits would thereby not move in high volatility. In boom times, they would profit less due to higher provisions whereas they would incur lower losses in bust times due to the allowance cushion.

Provisioning the default risk premium would promote countercyclicality. A loss allowance buffer would help banks absorb defaults without losing equity. Consequently, resilient capital structures would prevent banks from overreacting to delinquencies.

The International Accounting Standards Board (IASB) set International Financial Reporting Standards (IFRS). Most countries directly or indirectly adopt IFRS into their domestic accounting regimes. IFRS 9 - Financial Instruments guide how to recognize loans in banks. IFRS 9 sets forth a dual loss recognition mechanism, ex ante and ex post.

The current provisioning rules are dominantly ex post. A greater portion of the provision is exercised at the same time with the loss. Banks debit a loss account and credit a provision account based on the severity of the credit risk. The ex ante mechanism requires banks to estimate a 12-month expected loss for all outstanding credit. To recognize ECLs (expected credit loss), banks debit a loss allowance account and credit a provision account. Banks thus establish a loss cushion to absorb losses expected in the next 12 months.

In practice, banks provision an expected loss which is much lower than the default risk premium. The ex post provisioning rates vary between 20% and 100% based on how long a loan has not been served (D'hulster et. al. 2014). Because the expected loss cushion does not suffice to cover nonperforming loan losses, bank profits highly deviate based on the materialization of the credit risk. By the time a loan defaulted, a bank could have already collected most of the interest and distributed default risk premiums to its shareholders as profit. Hence, provisions do not cushion defaults during bust times. Procyclicality exacerbates financial crises as delinquencies impair bank capitals and prompt banks to credit rationing which further dampens spending.

Applying the ex ante provisioning mechanism of IFRS 9 dominantly would not warrant a robust banking system either. The current framework does not secure all default risk premiums since only the default risk of the outstanding credits is taken into account. Banks release default risk premiums of matured credits. A countercyclical provisioning regime would never allow default risk premiums to be incorporated into profit. Due to easy access to lending and growing incomes, insolvent borrowers increasingly survive during boom times. As the default risk accumulates in an economy, default risk premiums should also accumulate.

Reforming the capital regime

Macroprudential authorities have partially fixed the deficiencies of the provisioning principles. Authorities require banks to reserve capital for each additional loan at the origination. It sounds such as an ex ante provisioning mechanism.

Nevertheless, similar to the provisioning framework, the current capital regime requires to reserve capital as a percentage of outstanding loans. Thus, accumulated default risk is not covered by equity either. In a business cycle composed of a 10 years boom and 3 years bust, a bank would have distributed all default risk premiums of matured loans in the 11th year. It would have reserved a capital cushion only as a percentage of the outstanding loans.

Banks cannot resist long-lasting business cycles with the current equity structure. As a cycle lasts longer, bank leverages rise and credit default risk piles up. While the credit risk accumulates, equity does not. As a result, equities melt against surging delinquencies a protracted recession.

A sound capital regime would require banks to add default risk premiums to equity. As a business cycle lasts longer, banks would accumulate a higher level of equity. Thus, they would resiliently cushion severe recessions through a higher absorption capacity.

Countercyclical Capital Buffer

Basel Committee has formulated the countercyclical capital buffer (CCyB) to cushion the default risk accumulated in boom times. The CCyB is 2.5% at the highest and raised at the discretion of macroprudential authorities. The CCyB cannot ensure the accumulation of default risk premiums due to two reasons.

First, default risk premiums of matured credits may exceed 2.5% of the risk weighted assets in a long-lasting trend of output growth. Second, authorities may not raise the CCyB before the next recession hits. In the US, the Fed has not raised the CCyB before the COVID-19 shock. Because its formation also takes a few years time, the odds of entering a recession with full CCyB is low.

Conclusion

The capital and provisioning regimes of the banking sector are procyclical. Being aware of this fact, authorities introduced the countercyclical capital buffer. Nevertheless, the CCyB is raised at the discretion of authorities up to 2.5%. Therefore, it does not ensure the accumulation of default risk premiums as a cushion. Following long-lasting boom periods, banks cannot resist the materialization of the default risk accumulated in good times of the economy.

References

D’Hulster, Katia, Raquel Letelier, Valeria Salomao-Garcia. 2014. Loan Classification and Provisioning: Current Practices in 26 countries. Overview Paper / August. 2014. Financial Sector Advisory Committee. http://pubdocs.worldbank.org/en/314911450690270267/FinSAC-LoanClassification-Provisioning-Paper.pdf

Bank for International Settlements (BIS). 2017. IFRS 9 and expected loss provisioning - Executive Summary. https://www.bis.org/fsi/fsisummaries/ifrs9.htm