## _wp14170

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### I. Introduction — role of IAS 39, IFRS 9, and supervisors
- IAS 39 recognizes impairment losses based on an incurred loss model that permits recognition only when there is “objective evidence” of loss; this approach has been viewed as recognizing impairment losses “too little and too late.”
- IAS 39 will be replaced by IFRS 9, which was published by the IASB on July 24, 2014, but IAS 39 remains the guiding principle until IFRS 9 becomes effective in 2018.
- Over 100 countries and jurisdictions worldwide have adopted IFRS; the IASB Jurisdiction Profiles provides information for 130 jurisdictions.
- The IASB replacement project moved from an incurred loss model to an expected loss model to better align accounting and supervisory requirements, though whether the new model will meet expectations is yet to be seen.
- Supervisory capability requirements:
  - powers, willingness, and technical expertise in prudential supervision and accounting rules to ensure sufficient and timely loan loss provisioning.
- Purpose of the IMF paper: assist countries, FSAPs, TAs, and country surveillance in navigating differences between accounting and regulatory provisioning approaches.

### II. Key differences: IFRS (IAS 39) versus the Basel Regime
- IAS 39 (effective January 1, 2001) — incurred loss approach:
  - Requires occurrence of a loss event or events (trigger events or objective evidence) before impairment is recognized.
  - Impairment assessed and measured on an individual and group basis; group assessments are an interim step until losses can be associated with individual loans.
  - Measurement uses discounted cash flow: impairment = carrying amount − present value of estimated cash flows discounted at the asset's original effective interest rate.
  - Paragraph 62 supports use of estimates; additional amounts set aside for foreseeable credit losses without objective evidence are not reported in the Income Statement.
- Basel Regime — expected loss approach:
  - Distinguishes specific provisions (identified losses) and general provisions (unidentified or latent losses).
  - Default/past due under Basel II is implied at the threshold of 90 days overdue or borrower unlikely to pay.
  - IRB approach: expected losses calculated using Probability of Default (PD) and Loss Given Default (LGD) for exposures not in default.
  - Measurement of provisions is linked to capital ratio calculations; under the standardized approach general provisions can be included in Tier II capital subject to the limit of 1.25 percent of risk-weighted assets.
  - Under the IRB approach the excess of eligible provisions over expected losses can be carried to Tier II up to a maximum of 0.6 percent of risk-weighted assets.
  - Basel guidance endorses management judgment and avoids overly prescriptive formulaic valuation.

### III. Practical and supervisory implications
- The “dual-approach” creates diverging perspectives between accountants/auditors (accounting compliance under IFRS) and supervisors (credit risk assessment and capital adequacy enforcement).
- IAS 39’s principle-based nature leaves substantial room for judgment, risking insufficient provisions if misapplied or overly reliant on lagging indicators such as past due status.
- Supervisory actions required:
  - bridge gaps between accounting and supervisory requirements;
  - exercise judgment on sufficiency and timeliness of provisions;
  - retain prudential provisioning systems during IFRS transition as a check/reference point.
- Recent developments increasing focus on provisioning:
  - Asset Quality Review (AQR) in the EU;
  - European Banking Authority (EBA) initiative to unify definitions of non-performing loans and forbearance;
  - BCBS work on new supervisory guidance anticipating IFRS changes.

### IV. Observations from supervisory practice and policy guidance
- IMF FSAP reviews show supervisors have adopted a variety of supervisory approaches to ensure provisioning adequacy.
- Sound supervisory judgments are needed given imprecise nature of loan loss provisions assessment.
- BCBS “Sound Credit Risk Assessment and Valuation for Loans” (2006) provides high-level principles consistent with IFRS but is not intended to bridge accounting provisioning to capital adequacy measures.
- Revised Basel Core Principles for Effective Banking Supervision (2012) reinforced supervisors’ expectations regarding provisions (for example, CP 18, ECs 4, 10, 11, and 12).

### V. Policy priorities and recommended supervisory actions
- Ensure supervisors have powers and technical expertise to:
  - Assess banks’ credit risk management processes and methodologies.
  - Determine sufficiency and timeliness of loan loss provisioning relative to accounting and prudential requirements.
- Use supervisory judgment where IAS 39 provisioning may lag actual credit deterioration.
- Help banks navigate conceptual and practical differences between IAS 39/IFRS 9 and Basel approaches; resolve implementation issues (see Annex 2 for common issues).
- Maintain active supervisory oversight during the transition from IAS 39 to IFRS 9.

### Provisioning and Capital Treatment (selected key statistics and mechanics)
- 1.25 percent of risk-weighted assets: limit for additions of general provisions to Tier II capital under the Standardized Approach.
- 0.6 percent of risk-weighted assets: maximum under the IRB approach for excess eligible provisions carried to Tier II capital.
- Specific provisions:
  - reduce income and thus have an adverse impact on capital;
  - are not included in capital because they are established for expected losses explicitly tied to the exposures they cover.
- Under-provisioning is identified as generally the single greatest distortion in the calculation of capital and capital adequacy.

### The New Accounting Credit Loss Recognition Framework — IFRS 9 (published July 24, 2014)
- Objective: move to a forward-looking expected loss model to address criticisms that IAS 39 recognized losses “too little and too late.”
- Staged approach and measurement horizons:
  - First stage: 12-months’ expected credit losses are recognized.
  - Second stage: when assets experience “significant increase of credit risk,” life-time expected losses are to be assessed and measured.
  - Third stage: life-time expected credit losses when losses can be identified with specific assets; interest income accrual at this stage is on the net carrying amount and credit allowance (versus gross in first two stages).
- Measurement guidance requires:
  - (i) an unbiased and probability-weighted amount determined by evaluating a range of possible outcomes;
  - (ii) time value of money;
  - (iii) reasonable and supportable information available without undue cost or effort.
- Implementation considerations:
  - Banks can leverage existing credit risk management systems; significant judgment required, especially in determining “significant increase of credit risk.”
  - IASB intends to limit earnings management via disclosures on assumptions and sources of changes in allowance balances.
- Limitations and timing:
  - Use of a 12-month horizon in the first stage may result in insufficient provisioning.
  - Effective date postponed from January 1, 2015 to January 1, 2018.
  - Until effective, IAS 39 remains the accounting standard and supervisors must manage co-existence with the Basel Regime.

### Implications for Supervisors — operational and legal powers
- Supervisors should:
  - have operational independence, accountability, adequate resources, proper training, and good knowledge of IFRS and Basel Regime requirements;
  - maintain close cooperation between accounting and credit risk/capital experts within supervisory teams;
  - incorporate supervisory powers regarding provisioning into national legislation or regulatory reporting rules with enforcement power.
- Interaction with auditors:
  - Establish effective working relationships and ongoing communications with external auditors; use auditors’ work where appropriate.
- Experience:
  - Increased supervisory interventions on loan loss provisions after the global financial crisis in countries such as Ireland, Portugal and Bulgaria.

### Box 2 — Provisioning and Supervisory Practices (high-level findings and recommendations)
- Supervisory role and regulatory framework:
  - Supervisors should recommend or require higher provisioning than under IFRS if necessary to withstand expected losses.
  - Consistent with BCBS minimum principle guidance and Basel Core Principles.
- BCBS minimum principle guidance requires consideration of:
  - (i) leading economic and market indicators;
  - (ii) portfolio and borrower-specific characteristics;
  - (iii) lending policies and underwriting standards;
  - (iv) impact of increased risks from loan origination during expansionary periods;
  - (v) collection practices;
  - (vi) all other relevant information.
- Reconciling accounting and regulatory provisioning:
  - Grouping criteria under IAS 39 are similar to Basel II: default probabilities or credit grades, loan type, geographic location, collateral type, maturity, past due status.
  - IFRS group provisions remain incurred-loss based and differ from Basel II expected-loss provisions.
- When IFRS 9 replaces IAS 39:
  - May bring closer alignment with prudential standards and potentially result in higher and earlier credit loss recognition;
  - IFRS 9 still does not include unexpected credit losses (these remain covered by capital);
  - Supervisors will still need to impose additional provisions where IFRS 9 provisions are deemed insufficient.
- Supervisory preference: generally preferable to require higher provisioning rather than higher capital ratios without provisioning, since the latter would overstate capital.

### Common provisioning issues in IFRS-implementing countries and supervisory responses
- Problem areas requiring supervisory guidance:
  - write-off rules and criteria (IAS 39 lacks guidance);
  - recognizing and disclosing NPLs and forborne loans;
  - linking NPLs and impairment triggers;
  - recognition and reporting of interest on NPLs;
  - specific requirements for collateral valuations including periodic updates;
  - prudential treatment of restructured loans.
- Supervisory remedies:
  - regulatory provisioning supplements (e.g., applying a percentage to outstanding loans);
  - creation of a non-distributable capital reserve to capture regulatory-accounting shortfalls (regulatory provisions reflected in Retained Earnings rather than Income Statement);
  - enforcement actions, Pillar 2 add-ons, or capital charges where provisioning deficiencies persist.

### Annex highlights — supervisory powers and country practices (selected)
- Examples of supervisory powers in practice (country excerpts):
  - Australia: APS 220 allows APRA to require provision, reserve, or capital increases.
  - Belgium: NBB can apply adjustments to regulatory own funds when provisioning weaknesses identified.
  - Korea: implemented reserve for credit loss during transition to KIFRS; supervisors can order reclassification and additional provisioning.
  - Netherlands and Germany: limited direct power to increase accounting provisions, but can require increases in financial strength via dividend restrictions or capital requirements.
  - Spain and Italy: supervisors can require increases in provisions and take enforcement action if corrections not implemented.
- Transition issues and supervisory practices:
  - Day-one gain: advise banks to place “excess” pre-IFRS provisioning in a non-distributable reserve in retained earnings.
  - Decrease in provisioning on IFRS adoption: may violate regulatory requirements and require supervisory intervention.
  - Regulatory provisioning as supplement: supervisors enforce sustainable overall provisioning while preserving IAS 39 accounting treatment in Income Statement.

### Annex 2 operational guidance (selected)
- Use of existing prudential provisioning systems:
  - Legacy grading and matrix systems may be used if calibrated to produce IAS 39-consistent discounted cash flow outcomes or updated with current and foreseeable future information under IFRS 9.
- Financial and regulatory reporting implications:
  - Recommended prudential-accounting reconciliation: create a non-distributable regulatory reserve for shortfalls between accounting and regulatory provisions; regulatory provisions reported in Retained Earnings, not the allowance account.
- Interest income on impaired loans:
  - IAS 39 requires accrual of interest on all loans including impaired loans; interest income on impaired loans recognized by applying original effective interest rate to carrying amount net of impairment.
  - Some prudential regimes use non-accrual; neither IAS 39 nor IFRS 9 adopts a non-accrual principle—disclosure of both accrual and non-accrual results may aid comparability.
- Uncollectible loan write-off:
  - IAS 39 is silent on write-off timing; BCBS recommends timely charge-off to preserve accurate historical loss rates used in IAS 39 and LGD calibration.
  - Write-off does not require exhaustion of legal remedies; repayments on charged-off loans should be tracked and factored into historical loss rates.
- Collateral in possession:
  - On foreclosure, classify as held for sale under IFRS 5 and re-measure at lower of carrying amount and fair value less costs to sell.
  - Supervisors should ensure appraisals follow International Valuation Standards and challenge appraised values; discourage forbearance via overstated collateral valuations.
- Restructured loans:
  - Treat as impaired; classify prudently (generally no better than prior to restructuring), require demonstrated performance before upgrading, and provision for more favorable terms.

### Summary and concluding remarks
- Supervisors must ensure sufficient and timely loan loss provisioning and may require additional provisioning when IFRS provisions are insufficient.
- The incurred loss model under IAS 39 often recognizes impairment losses “too little and too late”; IFRS 9 is a step toward expected credit loss accounting but may still fall short of through-the-cycle coverage for higher-credit-quality loans.
- Supervisors need powers, willingness, ability, and technical expertise to balance prudential and accounting requirements, to impose additional provisioning where necessary, and to correct adverse incentives and bank behavior.
- Adoption of IFRS should be encouraged to promote transparency and comparability, despite deficiencies in IAS 39 and IFRS 9 regarding credit loss assessment and measurement.

*Source: IMF staff paper on loan loss provisioning under IAS 39 and supervisory implications (excerpts from _wp14170).*

### References .............................................................................................................

### _wp14170 - References .............................................................................................................

### I. Introduction — role of IAS 39, IFRS 9, and supervisors
- IAS 39 recognizes impairment losses based on an incurred loss model that permits recognition only when there is “objective evidence” of loss; this approach has been viewed as recognizing impairment losses “too little and too late.”
- IAS 39 will be replaced by IFRS 9, which was published by the IASB on July 24, 2014, but IAS 39 remains the guiding principle until IFRS 9 becomes effective in 2018.
- Over 100 countries and jurisdictions worldwide have adopted IFRS; the IASB Jurisdiction Profiles provides information for 130 jurisdictions.
- The IASB’s replacement project aimed to move from an incurred loss model to an expected loss model to better align accounting and supervisory requirements, but whether the new model will meet expectations is yet to be seen.
- Bank supervisors must possess powers, willingness, and technical expertise in prudential supervision and accounting rules to ensure sufficient and timely loan loss provisioning.
- The IMF paper aims to assist countries, FSAPs, TAs, and country surveillance in navigating differences between accounting and regulatory provisioning approaches.

### II. Key differences: IFRS (IAS 39) versus the Basel Regime
- IAS 39 (effective January 1, 2001) prescribes an “incurred loss” approach:
  - Requires occurrence of a loss event or events (trigger events or objective evidence) before impairment is recognized.
  - Impairment assessed and measured on an individual and group basis; group assessments are an interim step until losses can be associated with individual loans.
  - Measurement uses discounted cash flow: impairment = carrying amount − present value of estimated cash flows discounted at the asset's original effective interest rate.
  - Uses experienced judgment; Paragraph 62 of IAS 39 supports the use of estimates.
  - Additional amounts set aside for foreseeable credit losses without objective evidence are not reported in the Income Statement (see Annex 2.2).
- Basel Regime (Basel I, II, III and BCBS guidance) favors an “expected loss” approach:
  - Distinguishes specific provisions (identified losses) and general provisions (unidentified or latent losses).
  - Under Basel II, the notion of default/past due is incorporated; default is implied at the threshold of 90 days overdue or borrower unlikely to pay.
  - Under the IRB approach, expected losses are calculated using Probability of Default (PD) and Loss Given Default (LGD) for exposures not in default.
  - Measurement of provisions is linked to capital ratio calculations; under Basel I general provisions could be included in Tier II capital subject to limits.
  - Basel guidance recommends valuation not be solely prescriptive or formulaic and endorses management judgment.

### III. Practical and supervisory implications
- The “dual-approach” creates diverging perspectives between accountants/auditors (accounting compliance under IFRS) and supervisors (credit risk assessment and capital adequacy enforcement).
- IAS 39’s principle-based nature leaves substantial room for judgment, which can result in insufficient provisions if misapplied or overly reliant on lagging indicators such as past due status.
- Supervisors may need to bridge gaps between accounting and supervisory requirements and exercise judgment on the sufficiency and timeliness of provisions.
- Even after IFRS 9 is effective, some provisioning issues encountered under IAS 39 may remain relevant.
- Recent global developments highlighting provisioning importance include the Asset Quality Review (AQR) in the EU and the European Banking Authority (EBA)’s initiative to unify definitions of non-performing loans and forbearance measures.
- The BCBS has started work on new supervisory guidance on provisioning for internationally active banks in anticipation of the new IFRS framework and potential lack of convergence with U.S. GAAP.

### IV. Observations from supervisory practice and policy guidance
- IMF FSAP reviews show supervisors have adopted a variety of supervisory approaches to ensure provisioning adequacy (see Annex 1).
- Sound supervisory judgments are needed given the imprecise nature of loan loss provisions assessment.
- The BCBS “Sound Credit Risk Assessment and Valuation for Loans” (2006) provides high-level principles consistent with IFRS but is not intended to bridge accounting provisioning to capital adequacy measures.
- The revised Basel Core Principles for Effective Banking Supervision (2012) reinforced expectations of supervisors regarding provisions (for example, CP 18, ECs 4, 10, 11, and 12).

### V. Policy priorities and recommended supervisory actions (as reflected in the paper)
- Ensure supervisors have powers and technical expertise to:
  - Assess banks’ credit risk management processes and methodologies.
  - Determine sufficiency and timeliness of loan loss provisioning relative to both accounting and prudential requirements.
- Use supervisory judgment to address situations where accounting provisioning under IAS 39 may lag actual credit deterioration.
- Help banks navigate conceptual and practical differences between accounting (IAS 39/IFRS 9) and regulatory (Basel) provisioning approaches and resolve specific implementation issues (see Annex 2 for common issues).
- Maintain active supervisory oversight during the transition from IAS 39 to IFRS 9 given the potential persistence of provisioning challenges.

*Source: IMF staff paper on loan loss provisioning under IAS 39 and supervisory implications (excerpts from _wp14170).*

### 1.25 percent of risk-weighted assets; general provisions are intended to cover possible or

### _wp14170 - 1.25 percent of risk-weighted assets; general provisions are intended to cover possible or

### Provisioning and Capital Treatment (Basel II and Accounting)
- Under the standardized approach to credit risk, general provisions can be included in Tier II capital subject to the limit of 1.25 percent of risk-weighted assets.
- Under the IRB approach:
  - There is no option to explicitly include general provisions in Tier II capital.
  - The excess of eligible provisions (which includes specific and general provisions) over expected losses can be carried over to Tier II capital subject to a maximum of 0.6 percent of risk-weighted assets.
- Specific provisions:
  - Reduce income and thus have an adverse impact on capital.
  - Are not included in capital because they are established for expected losses explicitly tied to the exposures they cover.
- Under-provisioning is identified as generally the single greatest distortion in the calculation of capital and capital adequacy.
- Behavioral risk: When under stress, banks may have incentives to underestimate credit risk, misclassify impaired assets, and postpone recognition of losses to avoid large provisions that would depress stated performance and limit refinancing opportunities.

### Where Accounting (IAS 39 / IFRS 9) and Prudential (Basel II) Approaches Meet and Clash
- Commonalities:
  - Both approaches recognize credit risk and aim to measure resources to set aside to mitigate and absorb losses.
  - Experienced and professional judgments are permitted and relied upon under both approaches.
  - Common data expected to be shared includes common credit risk grades, historical loss rates, characteristics used to group loans for collective assessment, and observable data used to estimate credit losses or adjust historical loss rates.
- Main differences:
  - Conceptual/operational divergence: IAS 39 is incurred loss based; Basel II is expected loss based.
  - Under IAS 39, impairment losses are measured based on occurrence of loss events or objective evidence as defined by IAS 39.
  - Under Basel II, recognition of credit losses is based on expected loss, assessing economic and financial conditions and borrower’s ability to pay.
  - Terminology differs: “impairment loss” (accounting) vs “credit loss provisioning” (prudential).
- Practical outcome:
  - Prudential loan loss provisioning tends to generate provisions higher than those allowed under IAS 39.
  - Explanatory factors include: (i) different ranges of information allowed under the two approaches, (ii) different judgments used by banks in applying IAS 39, and (iii) lack of due scrutiny by auditors at times.

### The New Accounting Credit Loss Recognition Framework – IFRS 9
- Drivers and objectives:
  - The incurred loss model under IAS 39 was criticized for recognizing impairment losses “too little and too late” and promoting cyclicality.
  - In response, a move to an expected loss based model was undertaken after the global financial crisis with BCBS, FSB, G-20 involvement.
- BCBS “Guiding Principles for the Replacement of IAS 39” (August 2009) principles on provisioning and impairment:
  - reflect expected losses over the life of the portfolio, considering the loss experience over the complete economic cycle;
  - allow early identification and recognition of losses;
  - incorporate a broader range of available credit information;
  - allow for the use of professional judgment while using leading economic indicators, changes in underwriting standards and collection practices, and other relevant information;
  - allow for provisions for groups of loans with similar risk characteristics.
- IFRS 9 (published in July 2014):
  - Moves credit loss recognition to a forward-looking expected loss model.
  - Permits a wider range of information, including expectations of future credit losses, rather than only past and present information.
  - Stages and measurement horizons:
    - First stage: 12-months’ expected credit losses are recognized.
    - Second stage: When assets experience “significant increase of credit risk,” life-time expected losses are to be assessed and measured.
    - Third stage: Also calls for recognizing life-time expected credit losses when assets have deteriorated to the point where credit losses can be identified with specific assets; interest income accrual at this stage is on the net of the carrying amount and credit allowance (versus on the gross carrying amount in the first two stages).
  - Measurement guidance:
    - IFRS 9 does not mandate a particular measurement methodology.
    - Requires that measurement of 12-month and life-time expected credit losses should reflect:
      - (i) an unbiased and probability-weighted amount determined by evaluating a range of possible outcomes;
      - (ii) time value of money;
      - (iii) reasonable and supportable information available without undue cost or effort.
  - Implementation considerations:
    - Banks can leverage existing credit risk management systems and matrices (historical loss rates adjusted with current and reasonable and supportable forecasts, probability of default estimates).
    - Significant judgment required, especially in determining “significant increase of credit risk” and staging transfers.
    - IASB intends to limit earnings management opportunities via disclosures on assumptions and sources of changes in allowance balances.
- Limitations and timing:
  - Use of a 12-month horizon in the first stage may result in insufficient provisioning.
  - Effective date postponed from January 1, 2015 to January 1, 2018.
  - Until IFRS 9 becomes effective, IAS 39 remains the accounting standard and supervisors must manage co-existence of IAS 39 and the Basel Regime.

### Implications for Supervisors
- Supervisory role and powers:
  - Supervisors need clear understanding of similarities and differences between the two approaches and the technical expertise to make correct decisions and help banks bridge gaps during implementation.
  - Supervisors should ensure loan loss provisions are adequate for prudential purposes and may need to impose additional provisions when IAS 39 provisions are deemed insufficient.
  - The BCBS recommends supervisors evaluate banks’ processes for credit risk management and asset valuation and ensure adequate loan loss provisions; supervisors have the power and responsibility to require banks to re-assess and increase provisioning levels where appropriate.
  - It is advisable that supervisors retain a prudential provisioning system after IFRS adoption to provide a check and reference point for impairment estimates under IFRS.
- Operational requirements for effective supervision:
  - Supervisors need operational independence, accountability, adequate resources, proper training, and good knowledge of IFRS and Basel Regime requirements.
  - Supervisory teams require a high degree of cooperation between accounting and credit risk/capital experts.
  - Supervisory judgment and technical expertise are essential given the ambiguous world of loan loss estimation and the need for case-by-case decisions on assumptions and estimates.
  - Incorporation of supervisory powers regarding provisioning into national legislation or regulatory reporting rules (with enforcement power) is important to enable effective intervention.
- Cooperation with auditors:
  - Given the critical role of external auditors, supervisors are encouraged to establish effective working relationships and ongoing communications with them and may make use of their work where appropriate.
- Experience and consequences:
  - After the global financial crisis, supervisory intervention on loan loss provisions became more common in countries such as Ireland, Portugal and Bulgaria.
  - Greater supervisory involvement can help ensure consistency in classification and provisioning across banks and similar asset classes.

*Source: Excerpt from IMF working paper (content unit: _wp14170 - 1.25 percent of risk-weighted assets; general provisions are intended to cover possible or).*

### Box 2. Provisioning and Supervisory Practices

### Box 2. Provisioning and Supervisory Practices

### Supervisory role and regulatory framework
- Supervisors should pay close attention to the adequate level and reasonableness of provisioning and, if necessary, recommend or require higher levels of provisioning than those required under IFRS so as to withstand expected losses.
- This approach is consistent with the BCBS’s minimum principles for recognition of credit-risk related impairment (minimum principle), the Basel Core Principles, and Basel III.
- Failure to have adequate provisioning leads to a fundamental misstatement of capital adequacy.

### BCBS minimum principle guidance for provisioning estimates
- Provisioning approaches should allow exercise of professional judgment and require consideration of:
  - (i) leading economic and market indicators;
  - (ii) portfolio and borrower-specific characteristics;
  - (iii) lending policies and procedures, including underwriting standards;
  - (iv) the impact of increased risks from loan origination during expansionary economic periods;
  - (v) collection practices; and
  - (vi) all other relevant information.
- When credit risk assessment or provisioning deficiencies are significant and not remedied on a timely basis, supervisors should act promptly:
  - assess how deficiencies affect provisions and discuss with bank management;
  - recommend and enforce establishment of higher provisions where deficiencies affect provisions;
  - consider reflecting deficiencies through higher capital requirements and requiring adequate disclosure where deficiencies affect a bank’s capital position and/or are beyond the realm of provisions.

### Interaction of provisioning and bank behavior
- Capital without proper provisioning will be overstated; overstated capital may result in problems later.
- Without proper provisioning, behavioral incentives for foreclosure of collateral and effective asset workout may not occur.
- Proper provisioning is a requirement; there is no trade-off between provisioning and higher capital ratio.

### Examples of supervisory powers in practice
- IMF FSAP findings cite Basel Committee member countries with evidence of powers to require higher provisioning: Australia, Austria, Canada, France, Italy, South Korea, and Spain (level of intrusiveness varies).
- Alternatives where powers to demand provisioning increases are absent:
  - Belgium: corrections can be required by deducting the deficiency from a bank’s own funds.
  - Germany, Netherlands: imposing additional capital charges.

### Reconciling accounting and regulatory provisioning
- When assets are collectively evaluated for impairment, grouping criteria under IAS 39 are similar to Basel II: default probabilities or credit grades, type of loan, geographic location, collateral type, maturity, and past due status.
- Information used to calibrate historical loss rates for group assessment under IAS 39 can be used to formulate LGD rates under Basel II.
- Provisions assessed on a group or portfolio basis under IFRS are still incurred-loss based and differ from expected-loss provisions under Basel II.

### When IFRS 9 replaces IAS 39
- IFRS 9 may bring much closer alignment with prudential standards and could potentially result in higher and earlier credit loss recognition.
- Expected-loss recognition advantages:
  - reduces possibility of distributing overstated profits in dividends and bonuses during the upswing;
  - facilitates capital adequacy assessment;
  - provides investors with more transparent, timely, and relevant information about expected credit losses.
- IFRS 9 still does not include unexpected credit losses, which remain covered by capital.
- If provisions under IFRS 9 are deemed insufficient, supervisors will still need to step in and impose additional provisions where necessary.
- Operational efficiencies: infrastructure and data collected for regulatory compliance can be used as a basis for expected credit loss calculation under IFRS 9 (see IFRS 9, Paragraph BC 5.251).
- IFRS 9 was not designed to meet needs of both supervisors and investors; it presents neutral information as of the reporting date and defers to supervisors to decide sufficiency of loss allowances for capital assessment.
- BCBS is working on new supervisory guidance to reassess interactions between accounting rules and regulatory requirements and to revise or issue regulatory requirements accordingly.

### Balancing provisioning and capital requirements (Basel II / Basel III context)
- Under Basel II, future loan losses are classified into expected losses and unexpected losses:
  - Expected losses are measured as product of probability of defaults times loss given defaults and are compared to combination of specific and general provisions.
  - Unexpected losses are to be covered by capital.
- Under Basel III, if the combination of specific and general provisions is less than expected losses, the difference must be deducted from Common Equity Tier I.
  - Under Basel II the difference had to be deducted half from Tier I and half from Tier II.
- If the combination of provisions exceeds expected losses, only general provisions subject to a certain threshold can be added to Tier II capital:
  - additions to capital are subject to 1.25 percent of RWAs under the Standardized Approach, and 0.6 percent of RWAs under the IRB approaches.
- Supervisory preference: generally preferable to ask for higher provisioning rather than higher capital ratios without provisioning, since the latter would overstate capital.
- Regional practice: several Asian countries (Korea, Philippines, Singapore, Thailand, Hong Kong SAR, and China) imposed regulatory provisions when accounting provisions were deemed inadequate after IFRS implementation.
- Additional supervisory provisions should bypass Income Statements and be reported in reserves (see Annex 2.2 for reporting of accounting and regulatory provisions).

### Capitalization versus provisioning (Box 3 key points)
- Provisions cover expected losses; capital covers unexpected losses and provides loss-absorption capacity and monitoring incentives.
- The “capitalization approach” (using capital to mitigate rising impairment losses instead of increasing provisioning) has pros and cons:
  - Proponents: higher CAR avoids confusion for investors and adverse credit ratings caused by high provisioning.
  - Critics: overstates capital and retained earnings, conceals loan portfolio deterioration, lacks transparency, may delay corrective supervisory and management actions, and may not induce needed behavioral changes by banks.
- Higher provisioning reduces retained earnings and capital but may induce corrective bank actions (issuing equity, reducing dividends, slowing risky asset growth, workout of NPLs).
- On balance, requiring higher provisioning is preferable to requiring higher capital ratios without proper provisioning; nevertheless, where provisioning deficiencies are significant or not remedied, supervisors may consider reflecting such deficiencies through higher capital requirements.

### Common provisioning issues in IFRS-implementing countries and supervisory responses
- Many practical provisioning issues stem from absence of or inadequate guidance in IFRS, creating need for supervisory measures and policies to fill gaps.
- Supervisory guidance areas include:
  - formulating uncollectible loan write-off rules and criteria (IAS 39 lacks guidance);
  - recognizing and disclosing NPLs and forborne loans properly;
  - identifying formal links between NPLs and impairment triggers;
  - properly recognizing and reporting interest on NPLs;
  - setting specific requirements for collateral valuations including periodic updates;
  - treating restructured loans prudently.
- Table 1 summarizes common IAS 39 provisioning issues across topics: transitioning from local GAAP to IFRS; financial and regulatory reporting implications; interest income on impaired loans; uncollectible loan write-off; valuation and sale of collateral in possession; restructured loans.
- Detailed supervisory approaches and application under IFRS 9 are discussed in Annex 2.

### Summary and concluding remarks
- Supervisors must ensure sufficient and timely loan loss provisioning and may require additional provisioning when IFRS provisions are insufficient.
- The incurred loss model under IAS 39 often recognizes impairment losses “too little and too late,” and this problem may persist with IFRS 9.
- Supervisors need powers, willingness, ability, and technical expertise to balance prudential and accounting requirements, to impose additional provisioning where necessary, and to reinforce prudent provisioning practices to correct adverse incentives and inappropriate bank behavior.
- Because capital without proper provisioning risks overstating capital, higher provisioning is preferable to higher capital for mitigating rising impairment losses.
- Adoption of IFRS should continue to be encouraged to promote transparency and comparability, despite deficiencies in IAS 39 and IFRS 9 regarding credit loss assessment and measurement.
- IFRS 9 is a step in the right direction toward expected credit loss accounting, though it falls short of providing through-the-cycle credit loss coverage for higher-credit-quality loans; results of implementation are yet to be seen, and IAS 39 will remain relevant until IFRS 9 becomes effective.

*Source: Box 2. Provisioning and Supervisory Practices, IMF working paper content unit*

### Annex 1. Supervisory Powers in Loan Loss Provisioning in Selected Countries

### Annex 1. Supervisory Powers in Loan Loss Provisioning in Selected Countries

### Supervisory powers and practices by country
- Australia
  - The Banking Act empowers the Australian Prudential Regulation Authority (APRA) to make legally enforceable prudential standards (including those relating to credit quality, problem asset recognition and provisioning) and to issue formal directions to comply if necessary.
  - APRA has a general power to issue directions to banking institutions as to the way their business affairs are conducted; in practice authorised banking institutions (ADIs) accept APRA’s specific requirements without formal powers being invoked.
  - APS 220: an ADI must maintain provisions and reserves adequate to absorb existing and estimated future credit losses given the facts and circumstances applicable at the time; paragraph 41 allows APRA to require an ADI to increase provisions, reserves or capital or otherwise change policies and practices.
  - APRA may require an ADI to hold additional capital (Prudential Standard APS 110 Capital) and to rectify or make further public disclosures (Prudential Standard APS 330 Disclosure) if APRA views disclosures as inaccurate.

- Austria
  - On-site examinations may result in reclassifications of individual assets and additional loan loss provisioning requirements.
  - Within the Pillar II Supervisory Review and Evaluation Process (SREP), additional capital may be required based on overall risk assessment; the overall level of provisioning and risk management processes is considered in the SREP.

- Belgium
  - The National Bank of Belgium (NBB) is not empowered to modify the level of provisions reported in general purpose financial statements.
  - For prudential purposes, pursuant to article II.1, §1.b.v of the NBB Regulation of 15/11/2011 on own funds, the NBB can require corrections: element (v) relates to possible and predictable losses and costs for which, in the opinion of the NBB, necessary impairment or provisions have not been accounted for.
  - In practice, the NBB can apply an adjustment to regulatory own funds if provisioning weaknesses are identified.

- Brazil
  - The Supervisor may determine reclassification of credit operations and demand corrective actions including capital allocation for incorrectly classified operations (Resolution 2682).
  - On onsite inspection, the Supervisor may direct corrective actions and adjustments to financial statements.
  - Resolution no. 4019 allows the Supervisor to require financial institutions to increase capital as a prudential measure when deterioration (e.g., high level of classified assets threatening soundness) occurs, regardless of compliance with minimum capital requirements.

- Canada
  - Through detailed file reviews, recommendations for risk rating changes/additional provisions are normal supervisory work.
  - The Office of the Superintendent of Financial Institutions (OSFI) expects banks to make necessary adjustments and advise OSFI in their response; pervasive problems would prompt separate recommendations to improve risk rating and/or provisioning policies and procedures.

- France
  - Loan classification and provisioning are reviewed by French Prudential Supervisory Authority (ACP) inspectors in targeted credit risk reviews or general on-site reviews.
  - Off-site teams may recommend re-classifications and additional provisions based on reports; these recommendations are sent to external auditors, and auditors confirmed this occurred but infrequently.

- Germany
  - If risk classification, intensified loan management, treatment of problem loans and risk provisioning processes are inappropriate, Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) can issue an official order pursuant to Section 25a (1) sentence 8 of the Kreditwesengesetz (KWG) to remove shortcomings.
  - If shortcomings are not remedied, BaFin can impose additional capital charges, order risk-reducing measures and impose restrictions on deposit and credit business.
  - BaFin lacks power to demand an increase in provisioning levels, but its powers effectively allow it to “increase the overall financial strength” of an institution or seek risk deductions commensurate with perceived provisioning shortfalls.

- Italy
  - Inspectors assess internal asset classification and provisioning guidelines onsite; in cases of credit deterioration, the inspector assesses whether credit policy defines objectives, actions and timelines.
  - If classifications are inaccurate or provisions inadequate, adjustments are required; assessors have required banks to correct/offset inadequate provisions/classifications via Pillar 2 add-ons or reclassification.
  - When credit risk management is judged inadequate, the Bank of Italy (BI), on a case by case basis, has set higher minimum capital requirements for individual banks and banking groups or applies higher risk weights to specific categories of assets.

- Korea
  - In transitioning from Korean GAAP to KIFRS, authorities implemented a reserve for credit loss to prevent a decrease in loss absorbent capacity from accounting changes.
  - Regulatory reserves for IRB banks are determined based on the larger of either minimum regulatory ratios or expected losses under the IRB approach.
  - Financial Supervisory Service (FSS) examiners conduct off-site monitoring and on-site examination to assess asset classifications and provisioning; supervisors may order reclassification and additional provisioning where classifications are inadequate.
  - Regulations are sufficiently prescriptive for the supervisor to ensure banks fully reflect losses in the amount of provisions.

- Netherlands
  - The actual level of provisions is determined by the external auditor in line with accounting principles.
  - De Nederlandsche Bank (DNB) has no direct power to require a bank to increase provisions but will discuss adequacy with management and external auditor if it judges provisions inadequate.
  - Under the Decree of Prudential Regulations (DPR) Sections 3:18 and 3:18a, if DNB judges provisions inadequate it can require a bank to increase its financial strength, e.g., by restricting dividends or raising new capital.

- Spain
  - Article 47.a of the Banking Law of 1946 assigns responsibility to the Bank of Spain (BdE) to make recommendations concerning banks’ credit practices and policies.
  - Articles 4(f) and 5(k) make it a violation to have insufficient provisions and enable the BdE to take action to ensure accurate books.
  - Provision adequacy is addressed in letters sent after supervisory activities and may include a requirement to increase provisions; BdE takes enforcement actions when corrections are not implemented.

- United Kingdom
  - The Financial Supervisory Agency (FSA) requires banks and banking groups to have adequate information systems for measuring, assessing and reporting the size, composition and quality of exposures.
  - The FSA handbook requires effective processes to identify, manage, monitor and report risks (SYSC 4.1.1 R) and that banks ensure systems are sufficiently sound to support effective management and quantification of risks (GENPRU 1.2.89 G).
  - As part of the Advanced Risk Responsive Operating Framework (ARROW) assessment, FSA supervisors check management information quality and reporting to Boards and senior management; large banks are affected by common inadequacies in information technology systems that impede timely aggregation of risk information.

### Transition to IFRS and common provisioning issues (Annex 2 excerpt)
- Day-one gain and retained earnings
  - When transitioning to IAS 39, supervisors may face the “day one gain” issue: if provisioning before IFRS adoption is higher than allowed under IAS 39, supervisors should advise banks to place the “excess” in a non-distributable reserve in retained earnings.
- Decrease in provisioning on IFRS adoption
  - Upon transitioning, provisions based on IFRS are often lower than those estimated under the previous credit loss system; while compliant with IFRS for financial reporting, the decrease may violate regulatory requirements and require supervisory intervention.
- Regulatory provisioning as a supplement
  - To supplement inadequate provisioning after implementing IAS 39, banks can use regulatory provisioning—applying a percentage to outstanding loans or assets per credit risk analysis results (an approach practiced by certain countries).
  - Supervisors enforce sustainable overall provisioning levels while accounting and auditing staff should assure that financial statements appropriately apply IFRS in impairment loss recognition and measurement: only impairment losses recognized under IAS 39 are reflected in Income Statements, while additional regulatory provisioning is reflected in the non-distributable reserve.

*Source: Most recent IMF FSAP BCP assessments and country authorities.*

### Annex 2. 2).

### Annex 2. 2).

### Use of existing prudential provisioning systems and compliance with IFRS
- Pre-IFRS adoption practice: countries could follow prior national GAAP or regulatory rules using internal credit grading systems and a matrix to assess and estimate credit losses. Common loan categories include “pass,” “watch,” “substandard,” “doubtful,” “loss.”
- Grading systems classify loans by credit risk profiles, risk characteristics, and past due status; matrices assign a percentage or a range of percentages to each loan category to arrive at provision amounts.
- IAS 39 (and in applicable cases IFRS 9) does not preclude using internal credit grading systems for impairment assessment for individual or portfolio loans; grading systems include criteria such as asset type, geographic location, economic and financial indicators, risk profiles, and past due status.
- Limitations of continuing matrix-based provisioning under IAS 39:
  - Individually assessed loans: impairment measurement must follow the discounted cash flow method, taking into account collateral, per IAS 39. A matrix may only continue to be used if it is calibrated to yield the same loan loss provision amounts as the IAS 39 discounted cash flow model.
  - Collectively assessed loans: IAS 39 allows use of historical loss rate adjusted with current information as a proxy for present value of estimated cash flows when calculating impairment losses.
  - Prudential fixed loss rates or matrix ranges may be commensurate with IAS 39 estimates, but banks cannot default to regulatory approaches for financial reporting without ensuring results are materially consistent.
- Transition to IFRS 9: existing historical loss rate and PD may continue to be used, provided any data based on past events is updated with current and foreseeable future information.
- Practical guidance: banks may use legacy loan grading systems as analytical tools to gauge additional cushion needed for shortfalls resulting from IAS 39/IFRS implementation.

### 2.2. Financial and Regulatory Reporting Implications
- Two aspects of adopting IFRS:
  - Adopting IFRS for financial reporting.
  - Incorporating IFRS into regulatory reporting by banks to supervisory authorities.
- Sequencing and coordination:
  - A country often implements IFRS in one system first to build groundwork and enable banks to gain experience; simultaneous adoption in both systems is possible where resources and capacity permit and may yield efficiencies.
- Addressing provisioning shortfalls prior to IFRS reporting:
  - Supervisors should work with banks and external auditors to determine additional provisioning needed and how it should be assessed.
  - Countries planning to incorporate IFRS into regulatory reporting can formalize solutions when drafting regulatory reporting rules based on IFRS.
- Accounting treatment under IAS 39:
  - IAS 39 does not permit recognition in the Income Statement of impairment losses not based on objective evidence; additional regulatory provisions are not taken into account in arriving at current year net profits.
  - Excess of “regulatory” over “accounting” credit losses may be deducted from capital and equity and reported transparently.
  - Cumulative impairment losses measured per IAS 39 are reflected in the “allowance account,” a contra asset account (or a liability account) to net against gross loans.
- Recommended prudential-accounting reconciliation:
  - Create a non-distributable capital reserve, or regulatory reserve, for any shortfall between accounting and regulatory provisions.
  - Regulatory expected loss buffer is earmarked and reported transparently in Retained Earnings instead of current year net income.
  - Regulatory provisions are not reflected in the “allowance account” but as a reclassification within Retained Earnings, ensuring compliance with IAS 39 while satisfying regulatory requirements and maintaining financial statement transparency.
- Regulatory reporting examples and guidance:
  - Many countries have incorporated IFRS into regulatory reporting and promulgated prudential rules on top (example: EU FINREP template compliant with IFRS).
  - Whether following a standardized template or customized rules, the same reporting methodology should be adopted to ensure consistency with IFRS.
- Under IFRS 9:
  - The Income Statement will reflect expected credit losses, as defined by the IASB.
  - If provisions under IFRS 9 are deemed insufficient by supervisors, the manner of imposing additional provisions (expense account or reserve) is yet to be determined; frequency and scale of such events will be observable only after IFRS 9 has been implemented for a period of time.

### 2.3. Interest Income on Impaired Loans – to Accrue or not to Accrue
- Prudential practice in some jurisdictions: accrual of interest on NPLs not recognized as interest income; interest income recognized only when actually received (cash accounting). Cash received commonly applied to outstanding principal when full principal collection is not assured.
- IAS 39 requirement: interest on all loans, including impaired loans, is required to be accrued. Interest income on impaired loans is recognized by applying the original effective interest rate to the difference between the carrying amount of the loan and impairment loss.
- Practical tension:
  - Where substantial collection of principal and/or interest is in doubt, continuing accrual may record income and increase an asset not likely recoverable.
  - Some banks implementing IFRS continue to recognize interest income on impaired loans even when repayment is improbable, resulting in overstated interest income.
  - If cash is received when full principal collection is in doubt, cash should be recorded on a cash basis or reduce principal balance.
- IFRS 9 and alternative approaches:
  - IFRS 9 retained the interest income recognition clause under IAS 39.
  - The U.S. FASB’s Exposure Draft included a non-accrual principle that formally recognizes the non-accrual practice used by the U.S. banking system as an expedient in absence of U.S. GAAP guidance.
  - The BCBS called for revision of interest income recognition rules and replacement with a non-accrual clause for stage 3 assets in its comment letter on the IASB Exposure Draft.
- Disclosure recommendation:
  - Because neither IAS 39 nor IFRS 9 adopts a non-accrual principle, banks may risk violating IFRS by implementing non-accrual in financial reporting.
  - It may be helpful for banks to disclose results under both accrual (IFRS) and non-accrual (prudential rules) practices to allow users to compare impacts—this assumes banks maintain prudential provisioning systems after adopting IFRS.
- Operational guidance:
  - If a bank continues to receive reduced contractual or agreed interest payments, it should continue to accrue interest income at the reduced level and recognize revenue.
  - If substantial collection of all principal and/or interest is in doubt, cash receipts should reduce the principal balance first.

### 2.4. Uncollectible Loan Write-off
- Accounting mechanics:
  - Loan write-off involves removing some or all of an uncollectible loan from the books by reducing the loan balance (asset) and reducing the allowance account for loan losses (contra asset reflecting cumulative impairment).
  - When a loan is fully provisioned, net carrying amount is reduced to zero by netting the carrying amount and cumulative impairment losses in the allowance account.
- IAS 39 and write-offs:
  - IAS 39 is silent about the write-off of uncollectible loans; importance is implied in IAS 39 and IFRS 7.
  - IAS 39 allows use of historical loss experience in group impairment assessments; IFRS 7 requires disclosure of write-off criteria.
  - The accounting community considers specifying write-off timing as too prescriptive and leaves jurisdiction-specific guidance to local regulators.
- Supervisory guidance and rationale:
  - BCBS: timely charge-off of uncollectible loans is necessary to understand historic loss patterns by loan type and classification.
  - Accurate historical loss rates, taking into account timely write-offs, are important for IAS 39 compliance and for LGD calculation under Basel II.
  - Supervisors should have a general policy requiring timely write-off of uncollectible loans and assist banks in formulating sound write-off criteria; supervisors should require banks to back test loss rates and compare actual losses with applied loss estimates to ensure historical loss rates are not distorted.
- Write-off principles:
  - A bank should write off a loan or portion when it is considered uncollectible and of such little value that continuation as a bankable asset is not warranted.
  - Write-off does not require exhausting all legal remedies or giving up contractual rights on cash flows; it means the asset is not practical or desirable to defer writing off even though partial recovery may occur in future.
  - The rate of repayment of charged-off loans should be factored into the historical loss rate.
  - Safeguards: banks should maintain safeguards over loan documents and collection ledgers for loans that are written off but still have legal rights and potential for recovery.

*Source: Annex 2. 2).*

### Annex Box 1. Benefits of Timely Write-off of Uncollectible Loans

### Annex Box 1. Benefits of Timely Write-off of Uncollectible Loans

### Stronger transparency in financial reporting
- NPL figures that include legacy loans deemed uncollectible and the collection of which is not being actively pursued by the bank can disguise the level of loans that are newly problematic and actively being collected.
- Large quantities of fully provisioned loans that are deemed uncollectible can hinder the ability to understand the NPL coverage ratio.

### Cross-country comparability of aggregate banking sector information
- It is considered good practice to write off loans when the lender deems these loans to be uncollectible or of such little value that the loans are no longer considered bankable assets.
- Consistent application of these principles by banks in all countries applying IFRS would increase transparency and comparability of NPL levels and coverage for users of reported NPL information, including potential investors, banking supervisors, and supervisory oversight bodies.

### Greater accuracy in calibration of historic loan loss rates
- Historic loss rates, which are used for determining collective loan loss provisions under IFRS and the LGD for the Basel capital framework, require accurate and timely loss information.
- When banks delay writing off loans, these loss rates may not include the most recent and relevant loss information.
- Loss rates should be adjusted by subsequent recoveries.

### Potential for a more future-focused business environment for banks
- The markets take a dim view of banks with high levels of NPLs.
- When NPLs represent legacy loans that are fully provisioned and are not currently being pursued for collection, banks can stagnate under the cloud of these loans.
- When banks employ timely write-off practices, the balance sheet is cleansed and bank leadership can focus efforts on seeking new business and recovering from the effects of their resolved weak position.

### NPL ratio and NPL coverage ratio implications
- One of the concerns over uncollectible loan write-offs is that while write-offs will result in a lower NPL ratio, the NPL coverage ratio will also likely decline.
- This decline should present a truer view of the provision coverage for loans for which collection efforts are currently active, and a clearer picture of the shortfalls measured against an assessment of inherent credit risk.

### Impediments to loan write-offs and supervisory expectations
- Impediments include: court order dependence, a prolonged foreclosure process, tax disadvantages, and supervisory rules that may require exhaustion of all possibilities for the collection of claims and giving up contractual rights to the cash flows on the loans.
- All these will hinder banks’ ability to accurately calculate the historical loss rate.
- Expectations from accounting and regulatory standard setters is for supervisors to intervene and put policies in place that require banks to write off uncollectible loans on a timely basis, and hence fill the void left by the current accounting standards.
- In the absence of clearly defined write-off rules under IAS 39, supervisors and banks should not attempt to use IAS 39’s derecognition rules to guide the write-off of uncollectible loans.
  - The derecognition guidance within IAS 39 was designed to be applied to events such as the sale or transfer of financial instruments (e.g., repos, securities lending, and receivable factoring transactions) or when the financial rights to cash flows from a financial instrument expire, and not to the write-off of uncollectible loans.
- IFRS 9 only has high level guidance on loan write-offs; the new credit loss framework under IFRS 9 added language on timely loan write-offs that deal with both the entire loan and a portion of it.
  - There is still no specific guidance on write-off criteria, which would need to be determined by banks and supervisors.

### Valuation and sale of collateral in possession — valuation
- Two key aspects regarding treatment of collateral: (i) its role in loan classification and provisioning, and (ii) valuing and divesting it as a foreclosed asset.
- Collateral is taken into account in impairment loss recognition and measurement under IAS 39, though neither accounting nor regulatory rules have detailed guidance on its measurement.
- IAS 39 requires entities to estimate impairment losses based on the difference between the loans’ carrying amount and the present value of estimated cash flows, discounted at the loan’s original effective interest rate.
  - These cash flows may come directly from the borrower or may result from liquidation of the loan’s collateral.
- Estimates of cash flows from liquidating foreclosed collateral need to assume the remaining life of the asset, the timing of the sale of collateral, and the discount rate.
- Upon foreclosure, collateral in possession is classified as held for sale under IFRS 5 and re-measured at the lower of its carrying amount and fair value less costs to sell.
  - These assets are not subject to depreciation, although an impairment test is required and loss is recognized as the write-down to its fair value less costs to sell.
- Fair value measurement of collateral in possession should be supported by an independently qualified third party on a periodic basis.
- Supervisors should ensure appraisals for collateral in possession follow International Valuation Standards (IVS) as issued by the International Valuation Standards Council (IVSC).
  - IVS valuation methodology is market value or fair value based, and provides a good proxy of fair value.
  - Fair value definition under IVS is not identical with IFRS 13, which emphasizes exit price and market participants’ perspective.
- Supervisors should be prepared to be intrusive and challenge appraised values by evaluating a bank’s appraisal evaluation process, appraisal assumptions, inputs, conclusions, independence, and the capacity of the appraisal firms.
- Supervisors’ support of the establishment of a professional valuation industry and a central registry (or equivalent) for real estate and other property sales prices would enhance valuation quality over time.
- Supervisors should ensure proper mark down of property values and that banks write down the values of the collateral in possession based on reliable periodic appraised values.
  - Foreclosed properties have a high probability of incurring losses upon liquidation, and the value is not likely to increase as time goes by.
  - Allowing banks to continue to carry collateral in possession on their books at overstated values until they can sell it at a desired price is a form of forbearance, which hides losses and does not address the underlying issues.
  - In line with strengthening supervision, forbearance should be avoided during stable periods.
- In illiquid real estate markets or where the appraisal system is underdeveloped, supervisors should encourage banks to work with appraisers to estimate values and mark down properties given market illiquidity.

### Valuation and sale of collateral in possession — sale
- Assets classified in the held-for-sale category must be sold within one year, as required by IFRS.
- Auditors and supervisors should ensure the bank is committed to selling the property by having a plan to sell and actively marketing the property.
  - This includes checking listed property prices are reasonable in comparison to fair values and reflect the bank’s commitment to sell.
- IFRS 5 allows exceptions under which banks can exceed the one year limit; if supervisors permit a longer period, they must ensure the bank marks down property values based on periodic appraisals and recognize impairment losses against fair value less costs to sell.
- Supervisors should encourage banks to divest foreclosed assets and exercise their power to ensure (i) the appraisal system is robust enough to support fair value measurement per IFRS, and (ii) banks actively market and sell the foreclosed properties.
  - These steps help banks avoid opportunity costs, devote resources to core businesses, safeguard balance sheet integrity, and facilitate proper provisioning for collateralized loans.

### Restructured loans — prudential treatment and best practices
- Appropriate treatment of restructured loans is important for bank soundness both under normal circumstances and in a systemic crisis.
- IFRS acknowledges “renegotiated or otherwise modified” loans are impaired and should be subject to the same impairment loss measurement criteria.
- Bank supervisors should provide prudential guidelines on the treatment of restructured loans and monitor them carefully; banks should develop policies to ensure restructured loans are clearly designated, monitored and properly handled from accounting and loan review standpoints.
- At the time of restructuring, restructured loans should be assessed for collectability and thereafter identified in internal credit review systems and regularly monitored.
- Good practice elements for restructured loans:
  - Classification of a restructured loan: generally be classified as “substandard” or no better than its category prior to restructuring.
  - Performance before upgrading: after a reasonable period of demonstrated payment performance, banks could upgrade a restructured loan.
  - Relationship of additional debtor: if related or affiliated, original classification cannot be changed unless debt servicing improves; if unrelated, apply subjective loan classification to the new debtor in accordance with ability to repay.
  - Time period before upgrading: country practices vary; periods should encompass demonstrated payments and not simply passage of time.
  - Dealing with more favorable conditions: when restructuring offers more favorable conditions than market or original terms, a cost should be assigned to this difference and provisioned in its full amount.
  - Dealing with uncollectible restructured loans: when information confirms a restructured loan or a portion is uncollectible, write off this amount against provisions at the time of restructuring and regularly evaluate collectability thereafter.
  - Treatment in a systemic crisis: prudential norms and practices for classification and provisioning for restructured loans should be the same under normal circumstances as during a systemic crisis; supervisors should not exercise forbearance on classification and provisioning during depressed economic conditions.
- Best practices continue to apply under IFRS 9, which increased guidance on modified loans in the context of assessing and measuring 12-month and lifetime expected losses.
  - The IASB believes that: (i) a modified asset does not automatically have lower credit risk; and (ii) a debtor needs to have consistent good payment record for a period of time before the credit risk can be considered to have decreased.

*Source: _wp14170 - Annex Box 1. Benefits of Timely Write-off of Uncollectible Loans.*

### REFERENCES

### _wp14170 - REFERENCES

### Regulatory and supervisory publications
- Basel Committee on Banking Supervision (BCBS), 2006, International Convergence of Capital Measurement and Capital Standards (Basel II) (Basel: Bank for International Settlements).
- Basel Committee on Banking Supervision (BCBS), 2006, Sound Credit Risk Assessment and Valuation for Loans (Basel: Bank for International Settlements).
- Basel Committee on Banking Supervision (BCBS), 2009, Guiding Principles for the Replacement of IAS 39, (Basel: Bank for International Settlements).
- Basel Committee on Banking Supervision (BCBS), 2009, ILG Survey on Loan Loss Provisioning (Basel: Bank for International Settlements).
- Basel Committee on Banking Supervision (BCBS), 2012, Core Principles for Effective Banking Supervision (Basel: Bank for International Settlements).
- Basel Committee on Banking Supervision (BCBS), 2012, Minimum Principles for Recognition of Credit Risk Related Impairment (Basel: Bank for International Settlements).
- Basel Committee on Banking Supervision (BCBS), 2013, BCBS comment letter to the IASB on the Exposure Draft (Basel: Bank for International Settlements).
- Basel Committee on Banking Supervision (BCBS), 2014, External Audits of Banks (Basel: Bank for International Settlements).
- European Banking Authority (EBA), 2014, “Final Draft Implementing Technical Standards” (London: European Banking Authority).
- European Banking Coordination, 2012, “Working Group on NPLs in Central, Eastern and Southeastern Europe,” European Banking Coordination “Vienna” Initiative (Vienna).

### Accounting standards, exposure drafts, and accounting-sector commentary
- Financial Accounting Standards Board, 2012, Exposure Draft (Subtopic 825-15), Financial Instruments, Credit Losses (Washington).
- International Accounting Standards Board (IASB), 2001, IAS 18, Revenue, (London: International Accounting Standards Board).
- International Accounting Standards Board (IASB), 2003, IAS 40, Investment Property, (London: International Accounting Standards Board).
- International Accounting Standards Board (IASB), 2004, IFRS 5, Non-Current Assets Held for Sale and Discontinued Operations, (London: International Accounting Standards Board).
- International Accounting Standards Board (IASB), 2009, IAS 39, Financial Instruments, Recognition and Measurement, (London: International Accounting Standards Board)).
- International Accounting Standards Board (IASB), 2010, IFRS Conceptual Framework, (London: International Accounting Standards Board).
- International Accounting Standards Board (IASB), 2011, IFRS 7, Financial Instruments: Disclosures, (London: International Accounting Standards Board).
- International Accounting Standards Board (IASB), 2011, IFRS 13, Fair Value Measurement, (London: International Accounting Standards Board).
- International Accounting Standards Board (IASB), 2013, Exposure Draft (ED/2013/3), Financial Instruments, Expected Credit Losses, (London: International Accounting Standards Board).
- International Accounting Standards Board (IASB), 2014, IFRS 9, Financial Instruments, (London: International Accounting Standards Board).
- International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB), 2011, Financial Instruments: Impaired, Definition of “Write-off,” IASB/FASB Board Meeting Staff Paper (London: International Accounting Standards Board and Financial Accounting Standards Board).
- Fitch Ratings, 2005, “IFRS: and Their Implications for Bank Analysis and Analytical Spreadsheets” (New York: Fitch Inc.).
- Hoogervorst, Hans, 2012, “The Imprecise World of Accounting,” speech at IAAER Conference (Amsterdam).
- Hoogervorst, Hans, 2014, “Closing the Accounting Chapter of the Financial Crisis,” Speech delivered at the Asia-Oceania Regional Policy Forum (New Delhi).

### Empirical and academic studies on loan loss provisioning, provisioning practices, and bank behavior
- Angklomkliew, Sarawan, Jason George, and Frank Packer, 2009, “Issues and Developments in Loan Loss Provisioning: The Case of Asia,” BIS Quarterly Review, pp. 69–83 (Basel: Bank for International Settlements).
- Cortavarria, Luis, Claudia Dziobek, Akihiro Kanaya, and In Won Song, 2010, “Loan Review, Provisioning, and Macroeconomic Linkages,” IMF Working Paper 00/195 (Washington: International Monetary Fund).
- Erbenova, Michaela and In Won Song, 2010, “Regulatory Forbearance in a Financial Crisis,” IMF-MCM Technical Note, TN/10/01 (Washington: International Monetary Fund).
- Leventis, Stergios, Panagiotis Dimitropoulos, and Asokan Anandarajan, 2010, “Loan Loss Provisions, Earnings Management and Capital Management under IFRS: The Case of EU Commercial Banks,” Springer Science Business Media, LLC.
- Majnoni, Giovanni, Margaret Miller, and Andrew Powell, 2004, “Bank Capital and Loan Loss Reserves under Basel II: Implications for Emerging Countries,” World Bank Policy Research Working Paper 3437, (Washington: The World Bank).
- Novotny-Farkas, Zoltan and Joao Toniano, 2010, “The Implications of IFRS Adoption on the Valuation of Loan Loss Allowances,” First Draft Working Paper (Warwick: University of Warwick).
- Packer, Frank, and Haibin Zhu, 2012, “Loan Loss Provisioning Practices of Asian Banks,” BIS Working Papers No. 375 (Basel: Bank for International Settlements).
- Saurina, Jesus, 2009, “Loan Loss Provisioning in Spain. A Working Macroprudential Tool,” Estabilidad Financiera No. 17 (Madrid: Banco de Espana).
- Song, In Won, 2002, “Collateral in Loan Classification and Provisioning,” IMF Working Paper 02/122 (Washington: International Monetary Fund).
- Song, In Won, 2006, “Prudential Treatment of Restructured Loans,” in Bank Restructuring and Resolution, ed. By David S. Hoelscher, pp. 199–211(New York: Palgrave Macmillan).

### IMF and other international organization notes and operational papers
- International Monetary Fund, 2001, “Assessing Bank Equity,” IMF MCM Operational Paper 03/01 (Washington: International Monetary Fund).
- Viñals, José, Jonathan Fiechter, Aditya Narain, Jennifer Elliot, Ian Tower, Pierluigi Bologna, and Michael Hsu, 2010, “ The Making of Good Supervision: Learning to Say “No,” IMF Staff Position Note SPN/10/08 (Washington: International Monetary Fund).

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2014/_wp14170.pdf*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2014/_wp14170.pdf_