Regulatory treatment of accounting provisions - interim approach and transitional arrangements (IFRS 9)

General Information

This document, published in March 2017 by the Basel Committee on Banking Supervision, is an international standard regarding the regulatory treatment of accounting provisions in the context of implementing IFRS 9. It covers transitional approaches and the interim approach for the treatment of accounting provisions, particularly those related to expected credit losses (ECL). The scope includes banks subject to Basel regulatory frameworks, with implementation planned from January 1, 2018 for IFRS 9. The document comprises 14 pages and details the principles, methods, and rules applicable to the transitional period.

Executive Summary

The document addresses the regulatory impact of adopting expected credit loss (ECL) models introduced by IFRS 9, which replace incurred loss models. This transition leads to a potentially significant increase in accounting provisions, negatively affecting banks' capital ratios. The Basel Committee proposes to temporarily maintain the current regulatory treatment of provisions, based on the distinction between general (GP) and specific provisions (SP), despite this distinction being inadequate for the new ECL models. Furthermore, it recommends implementing optional transitional arrangements to mitigate the "capital shock" related to the increase in provisions upon adopting IFRS 9. Two approaches are proposed: a static approach (Approach A) that spreads the initial impact on CET1 capital over several years, and a dynamic approach (Approach B) that considers the evolution of ECL provisions during the transitional period. These arrangements must comply with strict principles, including a maximum transition duration of five years, linear amortization, and significant adjustments within the prudential framework, notably on deferred tax assets and the treatment of provisions in different regulatory pillars. The document also specifies associated transparency and disclosure requirements. The objective is to enable banks to adapt without destabilizing their capital, while encouraging adoption of ECL models for better credit risk management.

Context and Objectives

The document was drafted in response to the introduction of IFRS 9, which fundamentally changes credit loss provisioning methods by adopting an expected loss (ECL) model instead of the incurred loss model. This evolution aims at earlier and forward-looking recognition of losses, strengthening the banking system's resilience. However, it results in higher provisions, negatively impacting regulatory capital. Faced with these challenges, the Basel Committee sought to define an interim framework for the regulatory treatment of provisions to avoid abrupt capital shocks and allow an orderly transition. The document aims to present the principles and modalities of transitional arrangements, as well as related disclosure rules, while leaving open the reflection on the long-term regulatory treatment of ECL provisions. Limitations concern the temporary nature of the measures and the diversity of national practices complicating immediate harmonization.

Summary of Key Points by Theme

Current regulatory treatment of provisions: The Basel I and II frameworks distinguish general provisions (GP) and specific provisions (SP). GPs are limited to 1.25% of risk-weighted assets (RWA) in Tier 2, while SPs are treated differently depending on standardized (SA) or internal (IRB) approaches. This distinction, based on incurred loss models, is difficult to apply to IFRS 9 ECL provisions, which do not clearly differentiate GP and SP (p. 6-7). Interim approach: The Committee decides to temporarily maintain the current treatment of provisions under SA and IRB frameworks, recommending national authorities guide the classification of ECL provisions as GP or SP to ensure local consistency (p. 7). Transitional arrangements: Intended to avoid a capital shock, these arrangements are optional for jurisdictions. They must apply only to "new" provisions arising from ECL, excluding those existing before IFRS 9. The maximum duration is set at five years, with linear amortization of the adjustment on CET1 capital (p. 8-9). Approach A (static): The initial impact on CET1 capital is calculated at transition and spread over the transitional period. Example: a 350 million euro decrease in CET1 related to ECL provisions is amortized over three years, with 75% of the adjustment added back to capital the first year, then 50% the second, etc. (p. 10-11). Approach B (dynamic): Applicable to IFRS 9, it considers the evolution of Stage 1 and 2 provisions over the period. The adjustment is recalculated periodically, considering that some provisions are not "new" (e.g., IBNR provisions under IAS 39). A numerical example illustrates amortization over three years with adjustment of amounts (p. 11-13). Regulatory consequences: Adjustments must incorporate tax effects, notably excluding deferred tax assets related to non-deducted provisions. Non-deducted provisions must not be included in Tier 2 nor reduce exposures in SA or the regulatory leverage ratio (p. 9-10, 13-14). Transparency: Jurisdictions must publish the terms and rationale of transitional arrangements, and banks must disclose in their Pillar 3 reports the impact of arrangements on their capital and leverage ratios compared to a "fully loaded" basis (p. 10, 14).

Main Findings and Lessons Learned

Findings: The adoption of IFRS 9 leads to a significant increase in accounting provisions, negatively impacting banks' CET1 regulatory capital. The current regulatory distinction between general and specific provisions does not directly apply to ECL provisions. The Committee proposes to temporarily maintain the current treatment and allow transitional arrangements to mitigate the capital impact. Assumptions: The capital impact could be greater than expected, justifying the need for a transitional period up to five years. Static and dynamic approaches are considered to manage this impact. Interpretations: The Committee considers the transition must be gradual to avoid a capital shock and allow banks to adapt. It also highlights that national practices differ, requiring some flexibility. Uncertainties: The long-term regulatory treatment of ECL provisions remains to be defined, and actual effects on capital may vary by jurisdiction and accounting models applied (p. 5-14).

Conclusions and Recommendations

The Basel Committee recommends retaining the current regulatory treatment of provisions for an interim period, while introducing optional transitional arrangements to mitigate the negative impact of adopting IFRS 9 on CET1 capital. These arrangements must respect precise principles: application only to new provisions, maximum duration of five years, linear amortization, consideration of tax effects, and adjustments within the prudential framework to avoid double counting or excessive relief. Two approaches are proposed, static and dynamic, offering jurisdictions some flexibility. The Committee stresses the need for transparency, with publication obligations by authorities and disclosure by banks in their Pillar 3 reports. Finally, the Committee will continue its work to define the long-term regulatory treatment of ECL provisions, based on quantitative analyses and stakeholder feedback (p. 5-14).