LO 73.4: Examine the impact on the financial system posed by the standards.

LO 73.4: Examine the impact on the financial system posed by the standards.
The impact of the IASB standard would cause a dramatic rise in loss provisions at the start of an economic downturn, specifically the increase in amounts between stage 1 (12-month ECL) and stage 2 (lifetime ECL). One argument for a more proactive stance on recording losses is that it restates the balance sheet assets at more conservative levels to make way for possible future recoveries.
In one sense, the standards would have no impact for banks that have established sufficiently large capital buffers that could withstand the impact of the increased loan provisions.
The provisioning requirements of the standards could end up smoothing the issuance of loans throughout the economic cycle (i.e., slowing the growth of loans in a strong economy while preventing the slowing of growth of loans in a weak economy). That is because the prior provisions already taken on loans should prevent the capital cost of lending from increasing when the economy weakens. In a simulation exercise involving the earlier provisioning for loans, it was found that bad debts were lower (higher) in years when loan loss provisions were high (low). With earlier provisioning taken from capital, there would be reduced levels of lending prior to an economic downturn or crisis.
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Ke y Co n c e pt s
LO 73.1 Key reasons to provision for expected credit losses (ECL) include: 1. Determining a more accurate cost of lending.
2. Reducing the procyclicality of bank lending (by provisioning earlier for loan losses).
3. Reporting earnings in a more conservative manner, which may be useful to financial
statement users.
LO 73.2 There are two main differences between the IASB and FASB standards. 1. FASB requires ECL to be computed over the term of a loan commencing right from the
start while IASB requires a series of three stages.
2.
IASB permits the recording of accrued interest income on delinquent loans. FASB requires the use of the cash basis and/or the cost recovery method.
LO 73.3 Based on surveys conducted with banks regarding the implementation of IFRS 9, overall it appears that only minimal progress has been made as of 2016.
For many banks, there are currently weaknesses in general data quality and the computation of lifetime default probabilities for loans. In addition, many banks reported that they had insufficient technical resources to complete the implementation.
LO 73.4 The impact of the IASB standard would cause a dramatic rise in loss provisions at the start of an economic downturn, specifically the increase in amounts between stage 1 (12-month ECL) and stage 2 (lifetime ECL).
The provisioning requirements of the standards could end up smoothing the issuance of loans throughout the economic cycle (i.e., slowing the growth of loans in a strong economy while preventing the slowing of growth of loans in a weak economy).
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Topic 73 Cross Reference to GARP Assigned Reading – Cohen and Edwards
Co n c e pt Ch e c k e r s
1.
2.
3.
4.
5.
Forward-looking provisions for credit losses should be made: A. before loan origination. B. at the same time as loan origination. C. 3 months after loan origination. D. 12 months after loan origination.
For which measurement basis does IASB (IFRS 9) permit the recording of interest income on delinquent loans? A. Accrual. B. Cash. C. Cost recovery. D. A combination of cash and cost recovery.
Both the FASB and IASB standards measure loss given default (LGD) and exposure at default (EAD) as: A. backward-looking estimates. B. downturn estimates. C. forward-looking estimates. D. neutral estimates.
For banks that have been able to make estimates of loan loss provision increases, the percentages are, on average, closest to which of the following amounts? A. 3%. B. 20%. C. 33%. D. 50%.
Under the IASB standard, in which stage(s) would the impact of the provisioning rules be the greatest on a banks income statement? A. Stage 1. B. Stage 2. C. Stage 3. D. Stages 2 and 3.
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Co n c e pt Ch e c k e r An s w e r s
1. B The nature of forward looking provisions is that they should be made in the current period in anticipation of losses to occur in the future. Therefore, they should be made at the same time as loan origination. Provisions cannot be made before loan origination because there is no information available about the likelihood of default until the loan is actually originated.
2. A
IASB permits the recording of accrued interest income on delinquent loans, regardless of whether loan payments are being received. FASB requires the use of the cash basis (no interest income accrual), cost recovery method (payments applied to principal first, and once principal is repaid, the excess is recorded as interest income), or a combination of both in order to provide a more conservative and reliable method for income recognition on delinquent loans.
3. D Both standards measure loss given default and exposure at default as neutral estimates.
4. B For banks that have been able to make estimates, the loan loss provision increases are an
average of 20%, with the range typically being between 10% and 30%.
5. B There is a change from the one-year expected loss in stage 1 to a lifetime loss in stage 2,
which is a very dramatic change on the income statement. There is not much of a change on the income statement between stages 2 and 3 because lifetime ECL is reported in both stages, but interest revenue is reduced in stage 3 because it is calculated only on the carrying amount less the loss allowance.
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The following is a review of the Current Issues in Financial Markets principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
Bi g D a t a : N e w Tr i c k s f o r Ec o n o m e t r i c s
Topic 74
Ex a m Fo c u s
This topic focuses on ways to view the explosion in data that has resulted from the growth in economic transactions that involve computers. Large amounts of data are being captured daily and this trend will only increase over time. For the exam, understand that large datasets require tools beyond ordinary least squares (OLS) regression to properly understand the inherent relationships. Machine learning offers tools like classification and regression trees, cross-validation, conditional inference trees, random forests, and penalized regression. Further opportunities exist for the field of econometrics to bring time series forecasting tools to the world of big data.
Is s u e s In v o l v e d w it h Big Da t a s e t s