Dynamic Provisioning : Issues and Application

THERE IS CURRENTLY A LOT OF DISCUSSION about how to value financial instruments in companies' and – specifically in this context – banks' financial statements. Some advocate a move to full fair-value accounting; others promote so-called 'dynamic provisioning'. An article in the June 2000 Review set out some of the issues in relation to the former 2 ; this article looks at the latter. It first describes current practice with regard to bank loan provisioning and outlines how dynamic provisioning might work. It goes on to discuss the issues that would be involved in implementing dynamic provisioning, illustrating them with an example of a simple loan portfolio. These issues include how expectations of future losses might be set and whether dynamic provisioning could be used to smooth profits between accounting periods. Bank lending and the current approach to bank provisioning Under historic cost accounting, provisions are made for losses recognised at the balance sheet date. In relation to specific provisions, the UK Statement of Recommended Accounting Practice (SORP) on Advances 3 states that: " A loan is impaired when, based on current information and events, the bank considers that the creditworthiness of a borrower has undergone a deterioration such that it no longer expects to recover the advance in full ". Regarding general provisions, the SORP says that: " Experience shows that portfolios of advances often contain advances which are in fact impaired at the balance sheet date, but which will not be specifically identified as such until some time in the future…To cover the impaired advances which will only be identified as such in the future, a general provision should be made ". The distinction between the two is largely one of practical implementation: in both cases provisions are made only in respect of impairment believed to exist at the balance sheet date. The approach under US and international accounting standards is similar (Box 1). This accounting approach is rather different from the one implicit in banks' approach to lending. Banks expect that a proportion of their loan portfolios will be lost each year, as some borrowers will not be able to repay the loans. These are 'expected losses' , but actual losses may clearly be different from what a bank expects ex ante. Such unexpected losses could arise, for example, because of an unusually severe economic downturn. When calculating the unexpected loss, banks increasingly think in terms of …