FINANCIAL SECTOR ADVISORY CENTRE (FINSAC)

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FINANCIAL SECTORADVISORY CENTRE(FINSAC)LOAN CLASSIFICATION AND PROVISIONING:CURRENT PRACTICES IN 26 COUNTRIESOverview paper / August 2014Katia D’Hulster, Raquel Letelier,Valeria Salomao-Garcia

Loan classification and provisioning: Current practices in 26 countriesTable of ContentsAbbreviations and Acronyms . 2Preface . 3Executive summary . 4Introduction . 6A.Asset classification systems . 7B.Defining non performing loans . 10C.Restructuring or loan forbearance. 12D.Multiple loans to a single borrower . 15E.Collateral valuation . 16F.Write offs . 16G.Macro prudential aspects . 17H.Interactions between accounting rules and prudential regulations. 181)International Financial Reporting Standards . 182)Provisioning. 183)Accruing interest on non performing loans and reversing accrued interest . 23Conclusions . 25Annexes . 27Bibliography . 401

Loan classification and provisioning: Current practices in 26 countriesAbbreviations and AcronymsBCBSBasel Committee on Banking SupervisionEBAEuropean Banking AuthorityELExpected LossECAEurope and Central AsiaECBEuropean Central BankCRDCapital Requirements DirectiveFSIFinancial Soundness IndicatorsIASInternational Accounting StandardIASBInternational Accounting Standards BoardIFRSInternational Financial Reporting StandardsIRBInternal Rating-Based ApproachIMFInternational Monetary FundLGDLoss Given DefaultNPLNon performing LoansPDProbability of Default2

Loan classification and provisioning: Current practices in 26 countriesPrefaceKatia D’Hulster is a Senior Financial Sector Specialist at the World Bank Financial SectorAdvisory Center (FinSAC)Valeria Salomao-Garcia is a Senior Financial Sector Specialist at the Finance and MarketsPractice of the World Bank.Raquel Letelier is a Financial Analyst at the Finance and Markets Practice of the WorldBank.The findings, interpretations and conclusions expressed in this paper are entirely those ofthe authors. They do not represent the views of the International Bank for Reconstructionand Development/World Bank and its affiliate organizations, or those of the ExecutiveDirectors of the World Bank or the governments they represent.The authors would like to thank Damir Odak, Deputy Governor of the Croatian NationalBank, Henri Fortin, Pascal Frèrejacque, Joaquin Gutierez, Fernando Montes-Negret (allWorld Bank) and for their helpful comments and review.3

Loan classification and provisioning: Current practices in 26 countriesExecutive summaryThis study attempts to shed light on the regulations and practices in the area ofidentifying and provisioning for loans losses in 26 countries in EU countries and EmergingEurope. Our analysis is based on the World Bank Survey 2011-2012. Banking supervisionresponses were validated through a desk review of publicly available regulations.This overview paper has three objectives. First, we analyze some important considerationsthat make the comparison of NPL ratios and provisions across jurisdictions so challenging.Second, we explain the interactions between provisioning frameworks based on prudentialregulations and accounting standards. Finally, we conclude by sharing some good practicesfor NPL definitions useful for prudential supervisors who are considering aligning theirprudential frameworks more closely with IFRS. We also propose steps for further regionalwork, knowledge sharing and harmonization.In the area of NPL definition, we find that almost three quarters of the countries in theregion have some type of asset classification system in place covering all types ofborrowers, including sovereigns. Non performing exposures in the region are generallydefined by two criteria: 90 days past due or the unlikeness of the borrower to pay; and byother criteria such as significant financial difficulty of the borrower, bankruptcy andbreach of contract. There is neither a unified definition of forbearance or restructuring,nor a consensus when forborne exposures can be upgraded to the performing category andwhat the specific conditions for this upgrade should be. About one third of the surveyedjurisdictions allow an upgrade immediately after the forbearance and about half does notrequire an assessment of the borrowers’ creditworthiness before upgrade. The EuropeanBanking Authority has recently issued draft technical standards on loan forbearance whichcould be used as a guideline for harmonization of some of the diverging practices acrossthe region. About three quarters of the supervisors in the region require that when a loanis non performing, all other loans and credit exposures from the same borrower, or thesame economic group, are classified as higher risk, meaning that they apply a “singleborrower view”.In about half of the countries surveyed, regulatory and accounting loan loss provisioningstandards coexist. With regard to regulatory provisioning, less than half of the countriessurveyed allow collateral to be taken into account in their regulatory provisioning. Ofthose countries that consider collateral for provisioning purposes, the majoritydifferentiates between prime and non-prime collateral. In some countries, NPL ratiosinclude a high proportion of fully provisioned loans that remain on the balance sheet forlegal, judicial, tax or other reasons. These tend to inflate NPL ratios and the share ofprovisions allocated to non performing loans; or what is commonly referred to as thecoverage ratio. The vast majority of supervisors do not have criteria at what point in timethese exposures should be written off.As a general observation, regulatory provisioning frameworks are based on expected losses(EL), are more forward looking and result in higher provisions than IFRS standards.Divergence between accounting and prudential treatment also occurs in the recognition ofaccrued and unpaid interest on non performing loans. A little less than half of thesupervisors in this analysis do not allow accrued and unpaid interest on non performing4

Loan classification and provisioning: Current practices in 26 countriesloans to be recorded in the income statement; the remaining explicitly allow it or theirregulations are non-specific.Recently, some countries have come under pressure to do away with their traditionalregulatory provisioning and accrued interest adjustments and to rely exclusively onaccounting standards to determine provisions. In practice, the latter are oftenimplemented through the use of sophisticated risk management models that rely oninternally generated risk estimates and methodologies to calculate provisions. Substantialsupervisory resources should thus be allocated to analyze and benchmark banks’methodologies and risk parameters before full transition to these accounting frameworkscan be made. It is also essential to maintain both accounting and regulatory systems inparallel during this transition period.There is scope for a deeper understanding, more regional cooperation and sharing ofknowledge on banks’ provisioning practices among supervisors in the region. This couldinclude data collection and benchmarking of internal risk estimates, sharing of reviews ofthe provisioning methodologies and expected loss calculations applied by the bankinggroups active in the region and efforts to further analyze and harmonize NPL definitions.Home supervisors of major regional banks could also assist in this effort.5

Loan classification and provisioning: Current practices in 26 countriesIntroduction1.Even though it is often stated that NPL ratios and provisions are not easilycomparable across jurisdictions, non performing loans and their provisions in the Europeanand Central Asian (ECA) region are frequently charted and analyzed across multiplejurisdictions. As a result of the lack of harmonized regulations in this area, concernsregarding the consistency of loan quality assessments are frequently raised, particularlywith respect to the distinction between performing and non performing exposures,provisions for non performing exposures, as well as forbearance definitions.2.The objective of this study is threefold. First, we analyze some importantconsiderations that make the comparison of NPL ratios and provisions across jurisdictionsso difficult. Second, we explain the interactions between provisioning frameworks basedon prudential regulations and accounting standards. Finally, we conclude by sharing somegood practices for NPL definitions useful for prudential supervisors who are consideringaligning their prudential frameworks more closely with IFRS. We also propose steps forfurther regional work, knowledge sharing and harmonization.3.With regard to NPL ratios, the IMF Financial Soundness Indicators (FSI) CompilationGuide provides broad guidance for the identification of non performing loans by statingthat exposures are non performing if they are 90 days past due. 1 Implementing thisseemingly simple definition comes with a common set of policy choices; such as the exacttriggers for the classification as a non performing loan, the treatment of sovereignexposures, the handling of forbearance or restructuring, customer versus product view,the treatment of collateral, the timing of write offs and some macro-prudential aspects.While the above criteria are important, they are not the only policy choices to be made.They were selected for analysis in this paper because first; they are relatively simple tocompare across jurisdictions and, second; a variety of practices has emerged. Otherelements, for example the measurement of the non performing exposure – gross or net ofprovisions, collateral or the performing part - are not analyzed in detail in this paper.4.When it comes to setting provisions, there are complex interactions between, onthe one hand, prudential provisions and, on the other hand accounting or IFRS provisioningrequirements. Differences in practice have emerged, with some supervisors relying onaccounting definitions, others holding on to the regulatory provisioning requirements andsome selecting the higher of both outcomes for prudential purposes.5.For the purpose of this study, we perform a desk review of the range of regulationsand practices on loan classification and provisioning in 26 countries on the Europeancontinent. More specifically, the survey focused on Western Europe as well as ECA with 26countries surveyed. For some of the analysis, a distinction has been made betweenpredominantly home supervisors in Western Europe and the more typical host countries inthe ECA region. The countries included in the analysis are Albania, Bosnia Herzegovina,Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Georgia, Kosovo, Latvia, Lithuania,Macedonia, Montenegro, Poland, Romania, Serbia, Slovakia and Slovenia. Home countries1The FSI compilation guide of March 2006 recommends that loans (and other assets) should be classified asNPL when (1) payment of interest and principal are past due by more than three months (90 days) or more, or(2) interest payments equal to three months (90 days) interest or more have been capitalized (re-invested intothe principal amount), re-financed or rolled over.6

Loan classification and provisioning: Current practices in 26 countriesfor subsidiaries and branches operating in those countries, comprise Austria, Denmark,France, Germany, Italy, Greece, Norway and Sweden. The main source of information isthe World Bank Survey 2011 – Banking Supervision responses, validated through a deskreview of publicly available regulations. For the countries in the sample that have notparticipated in the World Bank Survey 2011, or where the responses diverged significantlyfrom the available regulation, clarification from the respective supervisory authorities wasobtained.6.This note concludes by providing good practice guidance on these key topics andthe main drivers for loan classification and provisioning. Importantly, the impact ofeffective im