Loan loss provisions: Are banks underproviding?

THE most controversial topic that has dominated the banking sector, apart from whether foreign banks should be indigenised and the US$100m capital requirements, is the level of reported impairments.

Report by Evonia Muzondo

 

It is quite unusual that although the economy has slowed down, banks’ profits continue to grow at an increasing rate. The performance of the sector is usually supposed to reflect general economic performance. It might well be that somewhere in the equation a false figure has been input or, alternatively, bank charges are out of all proportion.

 
A number of firms and individuals are failing to service their loans owing to the tight liquidity situation and this has cast doubt on the reported figures for loan loss provisions by banks. It is an acknowledged fact that there is a debt servicing problem in the economy.

 
Air Zimbabwe is said to owe millions to some banks as was also the case with Lobels Bakery. RioZim is entangled in a war with a number of banks after failing to repay their loans.Yet adversely classified loans in the sector as at December 31 2011 amounted to approximately US$200 million from a total loan book of US$2,7 billion. The June 2012 interims so far also show rather low loan provisions despite the much publicised liquidity challenges in the economy.

 

 

How come? Is somebody somewhere being economical with the truth?

 
This week the Minister of Finance was quoted as saying the state will assume banks’ non- performing loans by creating a special fund. He acknowledged that banks were sitting on high levels of non-performing loans. But the accounts reported by banks show otherwise. Does it mean then the Minister has access to the ‘true’ accounts? Is there a way  for the general public to verify this claim besides trusting that management are telling the truth as reflected in the published accounts?

 
An important question in all this though is; what are loan loss provisions and why provide them? Banks provide for loan losses so as to be able to absorb expected and unexpected losses from non-performing loans using available capital and retained earnings reserves.

 

 

This is also done to comply with best accounting practices and banking regulations. Displaying loans on a bank’s balance sheet as the amount of funds lent without indicating an adjustment for expected, but uncertain, future losses would be misleading and tantamount to withholding information. The income earning potential of the bank and its capital would also be overstated, making the bank appear stronger than it really is. In essence, how banks account for credit losses is important for the presentation of their  true and fair financial positions and therefore is a big area of interest.

 
As much as it is important, it is difficult, however, for a bank’s management to determine beforehand which loans will definitely not be repaid. Bank loans are by their economic nature private therefore there is not much market-based information to assess their current value at the time of distress. So that loan-loss provisions must often be estimated using reasonable judgement. Every now and then banks may be reluctant to provide for whole loan amounts because of the negative effects of bad loans on the profits and shareholders’ dividends.

 
According to local Banking Regulations 2000, Part IV Section 24, a loan is deemed uncollectable if it is graded a loss, with its capital and interest not having been repaid for more than 360 days after they were due.

 

 

The loan should be immediately written off the books of the bank and a provision of 100% of that loan be made in the loan loss account. A provision of 50% is mandatory if a loan is not serviced for a period between 180 days and 359 days. Such a loan is regarded as doubtful. A substandard loan is that which is not serviced for a period ranging from 90 days to 179 days and at least 20% of the loan value should be set aside. Loans not paid for more than 30 days but below 90 days are classified under special mention and require a provision of 3%. Those loans that will be in default for less than 30 days fall under the pass category and call for a 1% provision. The latter two categories are popularly known as special provisions.

 
From an accounting perspective, according to International Accounting Standard (IAS) 39, loans should be recognised as being impaired and the necessary provisions made if it is likely that the bank will not be able to collect all the amounts due — capital and interest — according to the contractual terms of the loan agreement. However, IAS 39 has been criticised for concentrating more on specific provisioning rather than general provisioning.

 
In other words, the standard favours actually-incurred loss provisioning, rather than expected loss provisioning. In essence, the standard is backward looking, whilst it is expected that provisioning be forward-looking.

 
Whilst regulators provide guidelines with which banks are expected to comply, the decision on whether to classify a loan as nonperforming is largely at management’s discretion and judgement and there is no formula to prove otherwise.

 
Management on the other hand are at times bound by performance targets linked to stock options. Reporting lower profits as a result of higher provisions is like asking a chicken to vote for Christmas.

 
Other central banks, like the South African Reserve Bank (SARB), have tightened their definition of overdue loans. Loans that are overdue by a month have to be reported. With reference to our own scenario the 360 days needed to classify a loan as non-performing appears to be too long.  The 1% general provisioning for performing loans also appears low as it might not be adequate to capture expected losses in the future.

 
There is also a trend for most of the loans to be classified as overdrafts. This loan category has less stringent provisioning requirements. At one point for one institution, approximately 67% of the advances were overdrafts and they had increased at a higher rate when compared to the increase in advances classified as loans. An overdraft is deemed as performing when the client’s account is active, not when the overdraft facility has been repaid.

 

 

This does not necessarily signal the debtor’s ability to pay. Regulation pertaining to provisioning of overdrafts states that if the account is still overdrawn beyond its overdraft tenure, it is classified accordingly and provisions are made. Some banks may have successfully managed to circumvent high provisioning through the overdraft route.

 
Despite the relevance of the topic, there isn’t a standard international benchmark to which regulators can refer.

 
The absence of international consensus is evident in the varying number of loan classification categories by countries;the treatment of multiple loans when one is in default; the inclusion or exclusion of loan guarantees; and collateral values when classifying a loan; the level of supervisory involvement in bank loan review processes, the treatment of restructured loans and the number of days used to define past due loans; the tax treatment of loan loss provisions;the backward or forward looking nature of losses to be provisioned; and the often poor disclosure standards. For example, in the UK, the supervisor does not require banks to adopt any particular form of loan classification.

 
Nevertheless, supervisors do expect banks to have a proper risk management process, including prudential appraisal of loans which should be updated regularly.

 
This difference in provisioning and classification approaches has often made a comparison of bank and banking system weaknesses  across regulatory regimes difficult and such differences have made market discipline less effective. In countries with strong legal infrastructure loans tend to be classified as past due relatively sooner.

 
It appears there is neither a uniform loan classification technique nor a standard procedure to assess loan risk. Furthermore, several concepts are susceptible to different interpretation. With no international consensus authorities across countries have designed their own regulations on loan classification and provisioning according to the specific nature of their regulatory environments.

 
The Reserve Bank of Zimbabwe, might help clarify the situation by introducing more stringent disclosure requirements in order to timeously detect loopholes before the credit bubble bursts. In the meantime it might be best to take banks’ reported profits with a pinch of salt!