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Comments on Nonperforming Loans Treatment in the Context of Financial Soundness Indicators (FSIs)
The initiative of the Joint Working Group on harmonizing terminology on classification and provisioning of nonperforming loans is highly appreciated, however it is an ambitious task given the variety of present country practices. The following paper highlights a few contentious issues requiring more attention and clarification as to definition and treatment. There are also some general comments attached to the end of this brief document.
- The term "provision" is used in fairly diverse contexts making the meaning somewhat obscure. It would be a great achievement to reach agreement on a consistent definition. Referring to the IMF Working Paper written by Cortavarria, Dziobek, Kanaya and Song (2000) - "It is important to differentiate clearly between the expense associated with provisioning and the resulting balance sheet item.1" Especially in context of FSIs the components need to be defined clearly in accounting terms to allow for a single interpretation and cross-country comparisons.
- Alternatively, a clear-cut understanding is necessary to separate those allowances, which build up capital items (general provisions) and those which end up as expenses in the income statement (specific provisions). In some instances it is hard to make clear separation between these two types of provision. One example is loan loss allowances for a class or pool of exposures with similar characteristics. On the one hand they resemble forward-looking (ex ante) provisioning, setting aside a cushion for non-identified losses. Normally the provisions made on pools are based upon historical loss experiences or anticipatory loan irrecovery rates. Corresponding to the latter, provisioning of pools tends to be pro-cyclical similar to specific provisions. The reason lies in the fact that in many countries (including Estonia) it is the bank's perception of risk which decides the rate of provisions made in respect of a pool. In this regard, the questions arise whether the provision made on pools:
- should be accounted for as a capital item in the balance sheet (general provisions) or as an expense (netted against assets in balance sheet) in income statement (specific provisions).
- may be included in Tier 2 capital for prudential purposes or not.
- The mixed model in regard of valuation of financial instruments has to be supported in view of the diverse nature of marketable and non-marketable (especially loans) instruments. As for loan exposures, it is preferable for impairment to be reflected through provisioning (in a separate account), in
order to enable two views - the expected receivable cash flows of the creditor as well as the true obligations of debtors. The last is very useful in order to give insight about general indebtedness of the real economy, especially for bank dominated financial markets.
- Since the new Basel Framework will require a very detailed and complex rating system within each asset class, the asset classification system as outlined in the IMF Working Paper2 seem to be too simplified on this background, at least for institutions intending to implement the internal ratings-based approach.
- Finally, the incentives for provisioning are also highly dependent on country's taxation system and prudential capital adequacy rules. Therefore it may be hard to implement sound provisioning practices in circumstances where the taxation or prudential regulation do not promote appropriate provisioning policy.
1Loan Review, Provisioning, and Macroeconomic Linkages. WP/00/195 Page 14, footnote 9.
2 Ibid, page 7
Bank of Estonia