Financial Instruments – Educational Session: Operational Challenges of an Expected Loss Provisioning Model
Four representatives from BNP Paribas appeared before the IASB 'as fellow thinkers' to discuss the operational challenges of the expected loss provisioning model. They based their assessment on the expected loss model put forward by the IASB staff in May 2009, and in particular Agenda Paper 5D. The BNP team attempted to illustrate how such a provisioning model might be applied in their circumstances.
A key question for financial institutions would be whether the expected loss method reduced pro-cyclicality in financial reporting or whether it would be counter-cyclical. Their initial reaction was that the expected loss model was less pro-cyclical than the incurred loss model, but was not counter-cyclical.
BNP Paribas had estimated that the cost of implementing an expected loss approach to loan loss provisioning would be significant and would extend for three years: one year for development of systems and two years for deployment. Variable rate assets were problematic, and the systems consequences of such instruments still needed to be explored. Speaking personally, one of the presenters thought that banks would be prepared to incur these significant costs if the approach reduced pro-cyclicality. However, the banks would probably not want to incur those costs if they also had to deal with an additional regulatory loss provision.
One problem with using the Basel II data is that it is very crude: the cut is short-term versus long-term, whereas the expected loss model would require more granularity in the data captured by the systems. Some operational efficiency could be achieved by being able to monitor portfolios of similar loans rather than individual loans, but that would also involve systems challenges, given the sheer volume of different types and maturities of loans involved. Again, this still needed to be explored.
Board members probed various aspects of the model with the presenters and clarified certain points. It was clear from the presenters that it would simplify their lives as preparers if there was a high degree of consistency between the data needed for loan loss provisioning for financial reporting and prudential regulatory purposes. However, it was also obvious that some Board members were still uncomfortable with some of the smoothing consequences of the expected loss model.
Both sides expressed a desire to continue to work collaboratively on exploring the expected loss model. The IASB staff reminded constituents that a Request for Views document is expected to be released later in June or very early in July 2009 and would explore the expected loss model in an attempt to gauge its feasibility.