Dear SAP Banking Community members,
Some days ago, I made some comments about the advantages of adding
Counter-Cycle Generic Provisions to the currently used system, based on
the generation of specific provisions recognizing losses on failed
loans.
Nevertheless, there’re some big difficulties on the implementation of a Counter-Cycle Provisions System.
First; we need a method to determine the volume of the provisions in a
way that represents the real (fair) value of the portfolio.
Additionally the system must be consistent in the both phases of the
economical cycle for avoiding any danger of arbitrary interpretations of
it, but it also must have the counter-cycle behavior for which it has
been designed, accumulating provisions on the expansion phase that will
be consumed on the recession phase.
The basic idea is to implement the model under the hypothesis that
failed assets are usually failed before they are actually “recognized”
or “visible” as failed.
In my opinion, from that hypothesis we can build the counter cycle behavior.
We must assume that on the expansion cycle we have a number of loans
which are actually failed, but they’re not visible as failed, as the
economic conditions, and even the optimistic feeling of the whole
financial system during the expansion cycle, prevents the failed loan to
be made visible.
On the contrary, during the recession cycle, that optimism is over; and
both, the failed loans generated on the recession phase, and those
failed loans generated on the expansion phase are all made visible (that
in fact generates the pro-cycle behavior of the current system).
If we build the provisions model using as the trigger of the provisions
the failed loans generated in the two phases of the economical cycle and
not only the “visible” failed loans, we’re closer to the Counter-Cycle
Provisions System we must achieve.
The difficulty is how to build a system which measures the non-visible failed loans.
What do you think?
Kindest Regards.
Ferran.
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1 comment:
How can we recognize failed loans before? Isn't it that the required key figures such as EAD take this into picture already? Depending on the counter party rating we calculate these parameters. In that case , if the loan is given to a company with a bad credit rating,based on the rating in the EAD calculation the % of capital to cover the loss arising from this loan will be a part of it. What is the need for generic provision ? Wouldn't this further increase the burden on the banks ? And the Basel 3 includes these calculations as well to find out the minimum capital required under stressed conditions ?
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