To provision or not to provision

Banks’ provisioning practices have come under increased scrutiny over recent years from accounting and taxation authorities and from financial supervisors. In part, this scrutiny reflects the important role that provisioning for loan losses plays in enhancing the transparency of banks’ balance sheets and the impact it has on the volatility and cyclicality of bank profits. Moreover, proposed reforms to the Basel Capital Accord have served to focus attention on the respective roles of provisions and capital in protecting a bank from credit losses. This growing interest is evident in a number of recent policy proposals and initiatives. These include: the development of an International Accounting Standard that addresses loan valuation and provisioning (IAS 39); the issuing of guidance on sound practices for loan accounting by the Basel Committee on Banking Supervision; the introduction of statistical provisioning regimes in some countries; and proposals by the Joint Working Group of standard setters to introduce fair value accounting for all financial instruments. While there are common elements to these various initiatives, there are also some significant differences. Importantly, opinions differ over the extent to which an objective deterioration in credit quality needs to be identifiable in individual loans before a provision can be created, and over the effect of loan pricing on provisioning decisions. Opinions also differ as to the relevant horizon for measuring expected credit losses and the appropriate interest rate to discount future cash flows. These differences of opinion reflect, in part, different perspectives. On the one hand, financial supervisors have tended to emphasise the role that provisions can play in ensuring that banks maintain adequate buffers against future deteriorations in credit quality. On the other hand, accounting authorities have stressed the importance of provisions in generating fair and objective loan valuations. This special feature discusses the main characteristics of a number of the recent initiatives and proposals, paying particular attention to the tensions amongst them. It also lays out a simple framework within which various proposals can be embedded and considers a number of alternatives to the current arrangements.