Tier I Tier I + Tier 2 + Tier 3
CHAPTER 7 CHAPTER 7
7.9 Loan Loss Provisioning Policy
offsetting accounting entry is made for a category called "interest in sus- pense." For reporting purposes the two entries must be netted, otherwise the assets will be inflated.
Second, when a bank places a loan in nonaccrual status, it should reverse uncollected interest against corresponding income and balance sheet accounts. For interest accrued in the current accounting period, the deduction should be made directly from current interest income. For prior accounting periods, a bank should charge the reserve for possible loan losses or, if accrued interest provisions have not been provided, the charge should be expensed against current earnings. A nonaccruing loan is nor- mally restored to accruing status after both arrears principal and interest have been repaid or when prospects for future contractual payments are no longer in doubt.
In some jurisdictions, a bank may avoid taking action on interest in arrears if the obligation is well-secured or the process of collection is underway. A debt is considered to be well-secured if it is backed by col- lateral in the form of liens on or pledges of real or personal property. Such collateral, including securities, must have a realizable value that is suffi- cient to discharge the debt in full according to contract terms or a finan- cially responsible party. A debt is "in the process of collection" if collec- tion is proceeding in due course, either through legal action or through collection efforts that are expected to result in repayment of the debt or in its restoration to current status.
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Assessments of asset value should be performed systematically, consis- tently over time, and in conformity with objective criteria. They should also be supported by adequate documentation.
Policies on loan-loss provisioning range from mandated to discre- tionary, depending on the banking system. The tax treatment of provisions also varies considerably from country to country, although many econo- mists believe that provisions should be treated as business expenses for tax purposes. Tax considerations should not, however, influence prudent risk management policies. In some highly developed countries, it is left to the banks to determine the prudent level of provisions. While some merit exists in estimating loss potential on a case-by-case basis, particularly for large borrowers, it may be more practical to assign a level of required pro- visions based on each classification category. In many countries, in par- ticular those with fragile economies, regulators have established manda- tory levels of provisions which are related to asset classification.
The established level of mandatory provisions is normally determined by certain statistics. In countries where the legal framework for debt recovery is highly developed, such as the United States, studies have demonstrated that approximately 10 percent of substandard assets eventu- ally deteriorate into loss. The percentages for doubtful and loss classifica- tions are approximately 50 percent and 100 percent, respectively. In devel- oping countries where the legal frameworks and traditions for debt col- lection may be less effective, provisions in the range of 20 to 25 percent of substandard assets may be a more realistic estimate of loss potential.
Table 7.3 can be used as a guide to the level of provisions in countries with less-developed legal frameworks.
TABLE 7.3 RECOMMENDED PROVISIONS
Classification Recommended Provisions Qualification
Pass .1-2 percent (Tier 2)
General loss reserve, if disclosed
Watch 5-10 percent Specific provision
Substfandanrd 10130 prceont Specific provision
Two approaches exist for dealing with loss assets. One is to retain loss assets on the books until all remedies for collection have been exhausted.
This is typical for banking systems based on the British tradition; in such a case, the level of loss reserve may appear unusually large. The second approach requires that all loss assets be promptly written off against the reserve, i.e., removed from the books. This approach is typical of the U.S.
tradition and is more conservative in that loss assets are considered to be nonbankable but not necessarily nonrecoverable. By immediately writing off loss assets, the level of the reserve will appear smaller in relation to the outstanding loan portfolio. In evaluating the level of provisions estab- lished by a bank, an analyst must clearly understand whether the bank is aggressively writing off its losses or is simply providing for them. The approach used in a particular country often depends on the taxation applied to provisions by the fiscal authorities.
Estimates of the level of necessary loan loss provisions necessarily include a degree of subjectivity. However, management discretion should be exercised in accordance with established policies and procedures. An analysis of adequacy of the overall allowance for losses should include the following aspects:
* A survey of the bank's existing provisioning policy and the method- ology used to carry it out. In particular, the value attributed to col- lateral and its legal/operational enforceability should be considered.
* An overview of asset classification procedures and the review process, including the time allotted for review.
* Any current factors that are likely to cause losses associated with a bank's portfolio and that differ from the historical experience of loss. These may include changes in a bank's economic and busi- ness conditions or in its clients, external factors, or alterations of bank procedures since the last review.
* A trend analysis over a longer period of time, which serves to high- light any increases in overdue loans and the impact of such increases.
* An opinion of the adequacy of the current policy and, on the basis of the loans reviewed, extrapolation of additional provisions nec- essary to bring the bank's total loan-loss provisions to a level in line with International Accounting Standards (IAS).