Dear,
As we commented in previous blogs, we’re in the middle of a systemic transformation; from a Financial System based in Volume to a Financial System based in efficient management of Capital.
And in a globalized Financial System, efficient Capital Management requires a commonly accepted regulatory framework, for measuring the Capital consumed by bank’s assets.
Today’s main sources of regulation for banks are; the International Accounting Standard Board (IFRS), and the Basel Committee on Banking Supervision (Basel III).
http://www.ifrs.org/About-us/IASB/Pages/Home.aspx
https://www.bis.org/bcbs/
The main responsibility of the BCBS is establishing the Capital Requirements for assuring the financial stability of the banking system, while the main responsibility of the IASB is establishing Fair Valuations of the assets.
Actually, both organizations are looking at the same problem, of measuring Capital consumption, from different perspectives.
- IFRS. The Fair Valuation of a Financial Assets, determines the provisions which adjust the Nominal Value of the Asset to a Fair Value, which includes the “Cost of Risk”.
- Basel III. The Capital requirements of an asset determine the capital consumed by investing (or lending).
It sounds reasonable to establish some level of reconciliation between the two approaches.
Basel III requires Banks to accumulate Capital during the expansion phase of the economic cycle, to cope with potential losses during the contraction phase of the economic cycle. These Countercyclical capital requirements are not linked to any particular loan, so they are Generic.
On the other hand, the International Financial Reporting Standards establishes the provisions, that banks must recognize, for covering the losses on their portfolio, due to events which have already happened and will affect future cash flows.
Part of these losses, come from detected failed loans, but others come from failed loans that we’re aware that exist in the portfolio, but we haven’t detected yet. For that reason, we have to evaluate the whole portfolio and adjust its value globally, also with the format of a Generic Provision.
But the problem remains, how to determine the Fair Provision for a non-visible failed loan?
An interesting approach for determining the value of these generic provisions, utilizes the Internal Ratings-Based Approach of the Credit Risk Calculation (Basel III).
For the IRB Credit Risk Calculation, we have to evaluate several components; the Probability of Default (PD), the Loss Given Default (LGD), the Exposure at Default (EAD) and the maturity of the contracts (M).
Additionally, the IRB approach let us calculate the expected losses of the portfolio (EL), which is the expected loss for every loan that we can calculate with the following formula:
EL=PD*LGD*EAD
As a driver of our reconciliation exercise, we're using the concept of Expected Losses of IRB, which is close to the concept of Incurred Losses of IFRS but not exactly the same.
The Expected Losses of the IRB approach is the average flow of losses that the internal rating calculation methods forecasts that is going to materialize in one year, while the Incurred Losses of the IFRS is the stock of existing losses of the portfolio at any given time, due to events in the past which will generate losses in the future.
Both, Incurred Losses and Expected Losses are different from the yearly manifested losses (flow of yearly defaults) and consequently the yearly flow of specific provisions.
Nevertheless, we can calculate the Incurred Losses according to the IFRS, by estimating the yearly flow of expected losses, and the time from the event which makes the loan failed, and the time when the failed loan becomes visible. This period between both events is called Loss Identification Period (LIP).
For instance if the counter-party losses his job, becoming incapable of fulfilling his payment obligations 18 months later, the Loss Identification Period would be 18 months.
Consequently if we know both magnitudes (the Expected Losses and the Loss Identification Period) we can estimate the Incurred Losses multiplying both.
For example, if the calculated Expected Losses of our portfolio (IRB Approach) are 45 million dollars/year and the average Loss Identification Period is 2 years, that means the Incurred Loss in our portfolio is 90 million dollars.
Incurred Losses (IFRS) = Expected Losses (IRB Approach) * Loss Identification Period
On the expansion phase of the economic cycle the Loss Identification Period is longer due to the easiness for refinancing policies supported but the good economic conditions.
And according to the formula the longer Loss Identification Period will make the Incurred Losses higher during the expansion phase.
This way, we’re reconciling the calculation of the IFRS Generic Provisions with the counter-cyclical capital buffer, requested by Basel III
Bringing the above method to the management of a real bank’s portfolio, requires an integrated Accounting (IFRS) and Risk (Basel III) management system, in a holistic data-model.
This is the foundation of the Integrated Financial and Risk Architecture of Bank Analyzer.
And this is what makes it the best system for measuring and optimizing the capital of a bank.
Looking forward to read your opinions.
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Kind Regards,
Ferran Frances.
