Lessons Learnt from the US Foreclosure Crisis

Supervisory Approaches to Promote Early Loss RecognitionMichael MooreInternational Monetary FundOctober 2014Vienna

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These are the views of the speaker not necessarily the IMF2

This session will discuss the supervisory complement to IFRS financial reporting

Context: the great recessionBehind the curve provisions and link to capitalDo supervisors have sufficient authority?Whose judgment is it?Policies and practice that augment accounting guidance getting ahead of the curveOnsite supervision: testing bank practicesRules: non-accrual, charge-offs, & collateral treatmentMarkets: disclosure and transparencySummary33

Euro Area NPLs: What a drag4

IMF direct Blog: What a Drag: The Burden of Nonperforming Loans on Credit in the Euro AreaBy Kerry, Portier, Ruggerone and Verkoren4

The stock of NPLs has doubled since 2009

Now more than euro 800 billion euro

Very little loan sales less than 6 percent

Resolution is hampered by three factors:

Bank financial capacity capital and provisioning buffers

Bank operational capacity deal with NPLs in house

Legal system capacity bankruptcy, insolvency processesEuro Area NPLs: What a drag55

The GIIPS and the US6

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Provisions proved too little7

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Enough capital ?8

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Enough capital ? - Nope9

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The capital handcuffs - the October IMF-GFSRReview of 300 banks in advanced economies found 25_percent did not have adequate capital to support lending growth of 5 percent a yearMost in Europe - about half the big banks (60 percent of assets)Why? Still nursing sick balance sheets that lack buffersTo dispose, restructure, collect NPLs, banks need to make provisions, but they need capital to make provisionsSome banks may have excess capital, but are slow to use it to deal with NPLs supervisors need to compel thisBanks that are undercapitalized, will need to raise it SSM hopefully answers this (?) (else its slow earnout)

Provisions and Link to Capital1010

Do Supervisors Have Sufficient Authority?1111

The supervisor determines that banks have adequate policies and processes for the early identification and management of problem assets, and the maintenance of adequate provisions and reserves. The supervisorassesses whether the classification of the assets and the provisioning is adequate for prudential purposeshas the power to require the bank to adjust its classification of individual assetshas the power to require the bank to increase levels of provisioning, reserves, or capitalMuddled interpretation: What does the law say? Just capital, or is there a hook to provisioning?The supervisors strong bias needs to be provisionsBCP 18: Problem Assets - Provisions and Reserves1212

IAS 39 - Impairment triggers seem sufficient and reasonable, also the role of judgmentExpert Judgment an entity uses its experienced judgment to adjust observable data for a group of financial assets to reflect current circumstancesSupervisors need to influence the judgment to:Ensure credible consistency across institutions on key metricsMandate adjustment to historical loss experience due to e.g., changes in the economy, property prices, unemployment rates IAS 9 - Is this really what we wished for?Even more complex models Even greater scope for variability in judgmentWhose judgment is it?1313

Supervisory policy and practice that compliment accounting guidance1414

Onsite evaluate effectiveness of banks credit risk policies and practicesAssess that banks have in place effective systems to reliably classify loans on the basis of credit risk Loan loss methodologies need to address both individually assessed and collectively assessed loansAssess validation of internal credit risk assessment modelsConclude views on model assumptions and expert judgmentsEvaluate information systems to ensure reliability

Onsite supervision: trust but verify1515

Remember when (in a pre-IFRS world) supervisory rules were suitable for the accounting standard?Illustrative ExampleStandard Assets:1% of the outstanding balance (Current to PD 90 days)Substandard Assets:20% of the outstanding balance (PD 90-180 days)Doubtful Assets:50% of the outstanding balance (PD 180-365 days)Loss Assets:100% of the outstanding balance (PD > 365 days)

Supervisory policy: rules overlay1616Supervisory policy: rules overlay

Regulatory approach overlays accounting principles

Rules based treatments augment within the accounting standards

Some country examples:IrelandUnited StatesSpain1717Supervisory policy: rules overlay (Cont.)This looks familiar? *

18* Bank of Spain circular 3/2010 to simplify accounting provisions for Spanish financial institutions. Allows recognition for real estate guarantees with specified haircut according to collateral type (e.g., primary residence more valued than land).18Supervisory policy: rules overlay (Cont.)

Ireland: introduced a rule to prevent ever-greening of loans: Renewal, refinancing, renegotiation, or restructuring of a credit facility will not interrupt the aging of arrears unless the borrower pays all interest without new financing.

1919Supervisory policy: rules overlay (Cont.)

20United States: Non accrual and charge off policiesNonaccrual policy obliged by the supervisor:Avoid overstatement of income & capitalPrompts early recognition of deteriorationEncourage managements corrective actionsNon-accrual treatment applied with scope to restore accrual if circumstances changeShould promote prudent work outsBanks are to promptly charge off identified losses

20Supervisory policy: rules overlay (Cont.)

United States: Non-accrual treatment

Suspension of interest for a loan that is 90 days in arrears unless well secured and in process of collection

Collection means legal action is proceeding and expected to result in recovery within the next 90 days

Restore to accrual if (i) loan is brought current, (ii) borrower makes sustained contractual payments (6 months), and (iii)_borrower likely to make all future contractual payments

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Keeping up Appearances22Example: effect of interest accrual on NPLs

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Keeping up Appearances23

Example Bank: effect of interest accrual on NPLs23Supervisory policy: rules overlay (Cont.)

United States: Charge-off rule for retail credit

At 180 days in arrears, banks to charge off any loan balance that exceeds the value of the property, less cost to sell

Charge off is not forgiveness of principal

Collection of charged off balances are recoveries (income)2424

The GIIPS and the US25

25 Supervisory policy: rules overlay (Cont.)

United States: Treatment of foreclosed assets When bringing the foreclosed asset onto the booksCharge-off further balance in excess of Fair Value less selling costs (net FV) shouldnt be much Transfer net FV from Loans to Other Real Estate Owned (e.g., bank-owned real estate)Subsequent valuation is lower-of-cost or market using valuation allowanceCompel prompt sale - banks must make good faith efforts to sell foreclosed properties at the earliest date (within five years)Special cautions when banks finance repossessed propertiesNo sale or gain if bank continues to control

2626Supervisory policy: rules overlay (Cont.)

27* Bank of Spain circular 3/2010Spain: treatment of real estate assets to compel prompt sale*

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IFRS-IASB proposes extensive disclosures about expected losses and changes in the credit risk of the loan portfolioLike Basel III, disclosure enough to allow markets to understand the nature of the NPLs, and provisioning. But what about frequency? Needs to be more frequent than annualDisclosures:Regulatory reporting: Supervisors should use regulatory reporting as a tool to disclose information to markets about individual institutionsMarket disclosures: should argue for quarterly reporting

Disclosure and transparency2828

Vigilance - capital and provision buffers needed to stay ahead of the curve Overreliance on auditors equals complacencySupervisory and regulatory policy must complement accounting guidance to promote early recognitionOnsite supervision must test loan classifications, provisioning and capital models; as well question judgments and force adjustment to policy, practiceSupplement accounting guidance with prudential requirementsUse transparency as a tool to compel adjustment

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Thank You

Michael Moore: Monetary and Capital MarketsInternational Monetary Fundmmoore@imf.org

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