The cyclicality of bank credit losses and capital ratios under expected loss model

Mahmoud Fatouh () and Simone Giansante ()
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Mahmoud Fatouh: Bank of England, Postal: Bank of England, Threadneedle Street, London, EC2R 8AH
Simone Giansante: University of Palermo

No 1013, Bank of England working papers from Bank of England

Abstract: We model the evolution of stylised bank loan portfolios to assess the impact of IFRS 9 and US GAAP expected loss model (ECL) on the cyclicality of loan write-off losses, loan loss provisions (LLPs) and capital ratios of banks, relative to the incurred loss model of IAS 39. We focus on the interaction between the changes in LLPs' charges (the flow channel) and stocks (the stock channel) under ECL. Our results show that, when GDP growth does not demonstrate high volatility, ECL model smooths the impact of credit losses on profits and capital resources, reducing the procyclicality of capital and leverage ratios, especially under US GAAP. However, when GDP growth is highly volatile, the large differences in lifetime probabilities of defaults (PDs) between booms and busts cause sharp increases in LLPs in deep downturns, as seen for US banks during the Covid-19 crisis. Volatile GDP growth makes capital and leverage ratios more procyclical, with sharper falls in both ratios in deep downturns under US GAAP, compared to IAS 39. IFRS 9 ECL demonstrates less sensitivity to lifetime PDs fluctuations due to the existence of loan stages, and hence can reduce the procyclicality of capital and leverage ratios, even when GDP is highly volatile.

Keywords: IFRS 9; IAS 39; US GAAP; expected credit loss model; loan loss provisions; cyclicality of bank profits; leverage ratio; risk-weighted assets (search for similar items in EconPapers)
JEL-codes: D92 G21 G28 G31 L51 (search for similar items in EconPapers)
Pages: 31 pages
Date: 2023-01-20
New Economics Papers: this item is included in nep-acc, nep-ban, nep-des, nep-fdg, nep-mac and nep-rmg
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:boe:boeewp:1013

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