With the upcoming implementation of IFRS 9 in 2018, the discussion of Basel III capital requirements and CECL / IFRS 9 is gaining importance. The relationship between capital and provisions for loan-loss has been a topic of discussion as the world moves towards mandating loss provisioning by looking out over the life of a financial asset. How will this new credit-loss approach for provisioning affect regulatory capital? The Basel Committee on Banking Supervision (BCBS) has begun addressing this question in a series of documents now available at www.BIS.org/publications.  This post summarizes some key takeaways from these publications.

“Accounting changes will affect bank regulatory capital.”

— Basel Committee on Banking Supervision

Basel III Capital Requirements Update

  1. Banks and credit unions need to think about the impact of CECL on regulatory capital now and
    factor it into their capital planning.
  2. As of March 2017, Basel has elected to retain the current regulatory treatment of accounting provisions for an interim period.
  3. At this point, the implementation of CECL is expected to lower CET1 capital because it will increase loss provisions.
  4. The BCBS is setting forth transitional arrangements to take effect January 1, 2018, for jurisdictions that choose to implement them. Under these arrangements, adjustments to CET1 capital (and by extension, to other regulatory capital measures) will be incrementally phased in. It was important for BCBS to establish these before the implementation of IFRS 9.

“In the short term, provisions may rise but the impact on regulatory capital is expected to be limited.”

— BIS Quarterly, March 2017

In the latest of five documents published by BCBS on Basel III capital requirements, the committee identified “a number of reasons why it may be appropriate for a jurisdiction to introduce a transitional arrangement for the impact of ECL (expected credit-loss) accounting on regulatory capital. These include:

  • The possibility that the impact could be significantly more material than currently expected and result in an unexpected decline in capital ratios; and
  • The fact that the Committee has not yet reached a conclusion on what should be the permanent interaction between ECL accounting and the prudential regime.”1

The transitional arrangements are as follows:

  • Approach A: Day 1 impact on CET1 capital spread over a specified number of years. If there is a decrease in CET1 capital due to an increase in provisions (net of tax effects) the amount of the decrease would be spread over several years (for regulatory purposes).2
  • Approach B: Phased prudential recognition of IFRS 9 Stages 1 and 2 provisions. This approach is for IFRS 9 and provides a phased approach using amortization of the capital differences.3

IFRS 9 vs. CECL (Expected Credit-Loss Models)

Regulatory Capital and CECL

Future BCBS releases will address the long-term regulatory capital treatment of loss provisions.  Recognizing these changes in both the computation of allowance for loan lease losses and its regulatory capital, an institution is required to adopt a more specific quantitative and risk governance framework than in the past. Previously computing the ALLL according to FASB requirements could be accomplished with adequate historical data and an Excel spreadsheet. By moving to life-of-loan approach, CECL requires institutions to take a more forward-looking view of their losses. This in turn will have a direct effect on the computation of regulatory capital.

It is not too early for institutions to begin thinking through the ramifications of this—not only how these measures will be accurately quantified and computed, but what their implementation will ultimately mean for P&L and liquidity.

[1] Basel Committee on Banking Supervision, Standards, Regulatory treatment of accounting provisions – interim approach and transitional arrangements, March 2017, pp. 3-4.
[2] Ibid, p. 6
[3] Ibid, p. 6