The Bank for International Settlements has released a document which sets out supervisory guidance on sound credit risk practices associated with the implementation and ongoing application of expected credit loss (ECL) accounting frameworks. The move to ECL accounting frameworks by accounting standard setters is an important step forward in resolving the weakness identified during the recent financial crisis that credit loss recognition was too little, too late. It is also consistent with the April 2009 call by G20 Leaders for accounting standard setters to “strengthen accounting recognition of loan loss provisions by incorporating a broader range of credit information”.
This guidance, which should be viewed as complementary to the accounting standards, presents the Committee’s view of the appropriate application of ECL accounting standards. It provides banks with supervisory guidance on how the ECL accounting model should interact with a bank’s overall credit risk practices and regulatory framework, but does not set out regulatory capital requirements on expected loss provisioning under the Basel capital framework.
The failure to identify and recognise increases in credit risk in a timely manner can aggravate underlying weaknesses in credit quality, adversely affect bank capital adequacy, and hinder appropriate risk assessment and control of a bank’s credit risk exposure. The bank risk management function’s involvement in the assessment and measurement of accounting ECL is essential to ensuring adequate allowances in accordance with the applicable accounting framework.
Supervisory guidance for credit risk and accounting for expected credit losses
- A bank’s board of directors (or equivalent) and senior management are responsible for ensuring that the bank has appropriate credit risk practices, including an effective system of internal control, to consistently determine adequate allowances in accordance with the bank’s stated policies and procedures, the applicable accounting framework and relevant supervisory guidance.
- A bank should adopt, document and adhere to sound methodologies that address policies, procedures and controls for assessing and measuring credit risk on all lending exposures. The measurement of allowances should build upon those robust methodologies and result in the appropriate and timely recognition of expected credit losses in accordance with the applicable accounting framework.
- A bank should have a credit risk rating process in place to appropriately group lending exposures on the basis of shared credit risk characteristics.
- A bank’s aggregate amount of allowances, regardless of whether allowance components are determined on a collective or an individual basis, should be adequate and consistent with the objectives of the applicable accounting framework.
- A bank should have policies and procedures in place to appropriately validate models used to assess and measure expected credit losses.
- A bank’s use of experienced credit judgment, especially in the robust consideration of reasonable and supportable forward-looking information, including macroeconomic factors, is essential to the assessment and measurement of expected credit losses.
- A bank should have a sound credit risk assessment and measurement process that provides it with a strong basis for common systems, tools and data to assess credit risk and to account for expected credit losses.
- A bank’s public disclosures should promote transparency and comparability by providing timely, relevant and decision-useful information.
Supervisory evaluation of credit risk practices, accounting for expected credit losses and capital adequacy
- Banking supervisors should periodically evaluate the effectiveness of a bank’s credit risk practices.
- Banking supervisors should be satisfied that the methods employed by a bank to determine accounting allowances lead to an appropriate measurement of expected credit losses in accordance with the applicable accounting framework.
- Banking supervisors should consider a bank’s credit risk practices when assessing a bank’s capital adequacy
In June 2006, the Basel Committee issued supervisory guidance on Sound credit risk assessment and valuation for loans to address how common data and processes may be used for credit risk assessment, accounting and capital adequacy purposes and to highlight provisioning concepts that are consistent in prudential and accounting frameworks. This document replaces the Committee’s previous guidance.
