Measuring the Performance of Bank Loans Under Basel II/III and IFRS 9/CECL

Abstract

In the last two decades, both internal and external risk management of banks has undergone significant developments. Substantial investments into data collection have been made and this data is used for estimating internal credit risk models. The resulting risk parameters are required for various regulatory purposes. Banking supervision encourages banks to use a risk-based approach for computing minimum regulatory capital. Accounting rules have been tightened requiring more timely loss reserves for impaired loans. In this article, we propose a comprehensive scheme for calculating the profitability of a loan that could be used both for setting risk-based interest rates when originating a loan and for accurately determining the profitability of existing clients. The scheme utilizes the credit models developed for regulatory purposes and takes the impact of regulation on loan performance into account. We show that accounting loan loss provisions cannot be applied in a performance measurement scheme because they do not reflect true economic loss. In addition, we demonstrate that it is crucial to measure loan performance over the full life cycle of a loan. Restricting profitability measurement to a time horizon of one year as often observed in practice could be misleading.

Keywords: Basel II, IFRS 9, CECL, RAROC, Loan Performance Analysis

JEL Classification: G21