May 02, 2019

ESRB published a working paper that studies the cyclicality in significant increase in credit risk using the mortgage modeling under IFRS 9. Banks must make forward-looking provisions for loan losses under new international accounting standards introduced in 2018. Using detailed loan-level data on the Irish mortgage market, the paper presents a framework for assigning mortgage loans into the three stages defined under the recent IFRS 9 accounting standards.

Assignment of loans into these stages will be central to provision calculations and stress testing exercises from 2018 on, but data limitations will prevail for some time, particularly for credit risk at origination. The delineation of performing loans into Stage 1 and Stage 2 is new and important for loan provisions, with the latter group being distinguished from the former on grounds of significant build-ups in risk since loan origination. In Europe, banks will assign performing exposures to a new “Stage 2” category with a higher provisioning penalty, if they have experienced a significant increase in credit risk. The authors use a loan-level credit risk model and Irish residential mortgage panel data to assign performing loans into the appropriate stage.

Using this technique, the authors characterize approximately 30% of the performing Irish mortgage portfolio at end-2015 as Stage 2. They then calculate backward-looking, static estimations of Stage 2 mortgages between 2008 and 2015. This exercise suggests that loan-stage assignment can be highly procyclical. The share of Stage 2 among performing mortgages rises during the economic downturn to peak in 2013, after which large transitions are assigned from Stage 2 into lower-risk performing loans, as the economy improves. The analysis of the end-2015 data shows that Stage 2 exposures could have comprised roughly 30% of performing exposures in the Irish mortgage market.

The study contributes to the debate on provisioning procyclicality by showing that the share of loans that would have been classified in the high-provision Stage 2 group rises from 5% to 50% of all mortgages during 2008-2012, in line with a sharp contraction in the Irish economy. Such a pattern suggests that a regime such as IFRS 9, relative to its IAS 39 predecessor, may lead to a smoother pattern for provisions during a downturn, while simultaneously having a higher correlation between provisions and the state of the economy. Further research is warranted on the exact mechanisms that underpin the procyclicality, or otherwise, of bank provisioning under various regimes as well as the general equilibrium effects on loan origination and bank capital.

 

Related Link: Working Paper (PDF)

 

Keywords: Europe, EU, Banking, Accounting, IFRS 9, Procyclicality, Credit Risk, Loan Loss Provisioning, Stress Testing, Mortgage Default, Loan Origination, ESRB

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