Provisioning Models vs. Prudential Models

Abstract

This article discusses the interaction of and relationship between accounting and capital rules. In 2018 accounting rules adopted IFRS9, changing the way provisions are calculated from an “incurred losses” to an “expected credit losses” paradigm (ECL). Following a broad description of provisioning and prudential models, the author analyses in greater detail how IFRS9 affects average capital requirements and their cyclicality. The conclusion is that under current capital requirement rules and the IFRS9 framework, both average capital requirements and their cyclicality will probably increase. Additionally, the author examines the foundations of current capital formulas that were developed under the incurred loss provisioning system. If it is true that ECL is a better predictor than the previous provisions mechanism, supervisors and regulators should conclude that a review of the capital requirement framework is needed in order to include this reduction in unexpected losses in the capital requirement calculation. On the other hand, if ECL does not prove to be a better predictor for real losses than the previous provisioning methodology, accounting regulators should rethink the ECL concept.