IFRS proposals for loan-loss provisioning should accelerate impairment costs for banks and drive them to report asset values more prudently than under existing rules, according to Fitch Ratings. But an expected loss approach could increase management judgment in the provisions taken.

The new standard should be more forward looking and better reflect managements’ own loss expectations as it removes the barrier to factoring forecast changes in economic conditions into the impairment charge. But this will involve considerable judgment. Fitch said it expects many banks to calculate their credit losses using estimates of probability of default (PD) and loss given default (LGD). Estimates of these assumptions modeled for Basel II purposes vary significantly among banks.

The categorization of loans into three “buckets” for the purposes of setting provisions also involves subjectivity. The proposals require banks to provide initially for losses expected over the next 12 months. If the credit quality of the loan then deteriorates, it passes into bucket two and full lifetime losses are used instead. The third bucket is for loans deteriorated to the point where there is “objective evidence of impairment,” Fitch said.

It is unclear how the three buckets correspond to the performing and non-performing categories banks already use. Without further explanation of the differences between the various categorizations, and details on the migration of loans between the buckets, analyzing asset quality may be challenging despite improved information available to investors under the new standard. Nevertheless, Fitch believes increased disclosure from the new IFRS will improve transparency and benefit users, particularly when these are combined with the take-up of recommendations around credit risk reporting by the Enhanced Disclosure Task Force, Fitch noted.

Meaningful comparisons between provisions reported by U.S. GAAP and IFRS banks are also likely to be difficult. The U.S. proposal goes further by front-loading all the losses for all loans rather than limiting this to loans with increased credit risk or those that are impaired. This could result in US banks ultimately reporting greater expected credit losses than their international peers. The divergence between the two standard-setters on this key measure may compromise their objective of providing transparency to the market, Fitch added.

It is difficult to estimate where impairment charges under the IFRS expected loss approach might end up, Fitch said. Basel II expected loss might provide some indication, but there are a number of significant differences between the two, with both positive and negative effects. Fitch believes that it is too early to conclude whether banks reporting significant Basel expected loss shortfalls will need to build comparable incremental provisions.

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