‘Ostrich approach’ to financial stability is a mistake

Denmark’s top supervisor, Jesper Berg, says scaling back IFRS 9 would be a costly error, despite the economic challenges raised by Covid-19

The highly damaging global economic impact of the Covid-19 pandemic has resulted in calls by many in the financial industry, as well as others, to show regulatory and accounting forbearance. A specific suggestion is to do away with International Financial Reporting Standard 9 (IFRS 9), postpone it or apply it with a light touch. All three of these proposals must be rejected.

IFRS 9 was developed in response to a key lesson learned from the global financial crisis – that bank accounts recognised impairments far too late. Under IFRS 9, there are three stages aimed at improving the the treatment of bank loan impairments. Stage 1 is made at the time of the granting of a loan, whereby 12-month expected credit losses are recognised in the profit or loss account, and a loss allowance is established. Interest revenue is calculated on the gross carrying amount. Stage 2 occurs when the credit risk increases significantly and is not considered low. Here, the full lifetime of expected credit losses are recognised in the profit or loss. The calculation of interest revenue is the same as in Stage 1. Stage 3 occurs when the credit risk of a financial asset increases to the point that it is considered ‘credit-impaired’. Here, lifetime expected credit losses should be recognised. Interest revenue is calculated based on the amortised cost.

There is widespread criticism that IFRS 9 and its impairment rules are procyclical. When the economy tanks, impairments increase, credit losses go up and capital goes down. As a result, the lending capacity of banks declines, corporates are refused credit, some ultimately may go bankrupt, banks lose more money, the economy faces further strains, and so on. This is the so-called ‘financial accelerator’.

‘Lemons’, not ‘peaches’

But consider what happens if banks wait with the impairments until they realise losses. Will they act as if nothing has happened, as during a sharp economic downturn? Will their investors and suppliers of liquidity act as if the banks continue to be good credit risks themselves?

Starting with investors and suppliers of liquidity, they will face increased uncertainty, when assessing the credit risk of the banks. They will make their own assessment and add an ‘uncertainty premium’. Their assumption will be that bank accounts reflect the accounts of ‘lemons’ and not ‘peaches’, to use the expressions that Nobel Prize-winning economist George Akerlof used to describe the used car market.

Banks will then feel the heat. They can then choose one of two strategies, recognising that ‘business as usual’ will not work. They can close all shutters and stop lending, as in the financial accelerator model. Alternatively, they can gamble for resurrection.

How can this be avoided? By ensuring that the banks are well capitalised and have ample liquidity. This should ensure one does not end up in a situation where there is a need to fudge the accounts. In fact, this has been the strategy pursued by most regulators and supervisors since the financial crisis. Fortunately, in most countries, banks are now in a much better situation than prior to or during the financial crisis. This does not imply that a severe crisis cannot test the resilience of banks, but this is not the primary concern.

The reality is ostriches survive because they are fast and strong, and everybody can see that they can kick forcefully

Almost all accounting rules are procyclical because the world is cyclical and accounts should reflect reality. Legend has it that the ostrich sticks its head in the sand in the belief that nobody can then see it. The reality is ostriches survive because they are fast and strong, and everybody can see that they can kick forcefully. Financial overseers should avoid taking an ‘ostrich approach’ (that of the ostrich myth) to banking accounts, so creating asymmetric information that ends up creating a ‘lemon market’ (where everyone assumes the loans are in poor condition) that cannot serve the economy.

IFRS 9 is not easy to apply – and a rapid downturn, as is happening now, does not make it any easier. Banks will have to revisit loan ratings. They will have to make assumptions as to likely economic scenarios. Nobody expects banks to nail it immediately. Initially, portfolio assessments and management judgements will substitute for changes to individual ratings. There is no expectation either that banks apply doomsday scenarios. The effect of government interventions should be included in the economic scenarios, and official economic projections are a sensible starting point. However, best efforts should be applied.

The US approach to financial stability during the financial crisis – to quickly deal with problem loans, rather than to engage in heavy forbearance – is in retrospect considered the right approach. The US forced banks to recapitalise so they could continue to lend to the economy. The worst thing that can happen during this crisis is if their own accounting tricks blind authorities so that they do not ensure adequate and timely capitalisation of banks. This will lead to zombie banks and zombie corporates at the cost of bank creditors, taxpayers and the economy.

Jesper Berg is the director general of the Danish Financial Supervisory Authority.