Expected Loss Model and the Cyclicality of Bank Credit Losses and Capital Ratios

20 Pages Posted: 13 Nov 2020

See all articles by Mahmoud Fatouh

Mahmoud Fatouh

Bank of England; University of Essex; Bank of England

Simone Giansante

University of Palermo - Department of Economics, Business and Statistics; University of Bath - School of Management

Date Written: November 11, 2020

Abstract

We simulate the evolution of stylised loan portfolios to assess the impact of IFRS 9 and US-GAAP expected loss model (ECL) on the pro-cyclicality of realised losses and capital ratios of banks, relative to the incurred loss model of IAS 39. We focus on the interaction between the changes in loan loss provisions (LLPs) charges (flow channel) and stocks (stock channel) under ECL. Our results show that ECL model smooths the impact of credit losses on profits and capital resources, reducing the pro-cyclicality of capital and leverage ratios, especially under US GAAP. However, when GDP is highly volatile, the large differences in lifetime probabilities of defaults (PDs) between booms and bust cause sharp increases in LLPs in deep downturns, as seen for US banks during the COVID-19 crisis. Volatile GDP makes capital and leverage ratios more pro-cyclical and cause sharper falls in both ratios in deep downturns under US GAAP, compared to IAS 39. IFRS 9 ECL shows less sensitivity to lifetime PDs fluctuations due to the existence of loan stages, and hence reduces the pro-cyclicality 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

JEL Classification: D92, G21, G28, G31, L51

Suggested Citation

Fatouh, Mahmoud and Giansante, Simone, Expected Loss Model and the Cyclicality of Bank Credit Losses and Capital Ratios (November 11, 2020). Available at SSRN: https://ssrn.com/abstract=3728699 or http://dx.doi.org/10.2139/ssrn.3728699

Mahmoud Fatouh (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

University of Essex ( email )

Wivenhoe Park
Colchester, CO4 3SQ
United Kingdom

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Simone Giansante

University of Palermo - Department of Economics, Business and Statistics ( email )

Viale delle Scienze
Palermo, 90100
Italy

University of Bath - School of Management ( email )

Claverton Down
Bath, BA2 7AY
United Kingdom

HOME PAGE: http://people.bath.ac.uk/sg473/index.html

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