Many euro zone banks are still far from meeting accounting rules on the provisions needed to protect against loan losses, despite some progress in factoring in climate risks, the European Central Bank's top supervisor said on Tuesday. A decade-old accounting standard designed to avoid a new banking crisis requires lenders to make an upfront provision when they make a loan, and then a fuller one if there are signs of potential default, rather than waiting for it to go unpaid.
But euro zone banks are dragging their feet in applying the International Financial Reporting Standard 9 (IFRS 9), Claudia Buch said, repeating a concern shared by other European regulators. "While progress has been made, especially in the area of climate and environmental risks, many banks are still far from meeting the expectations of IFRS 9," Buch told an ECB conference.
The proportion of unpaid loans on the balance sheet of euro zone banks has shrunk to a historic low since the financial and debt crises of 15 years ago, partly thanks to the ECB's own pressure on lenders.
But a surge in interest rates and new geopolitical risks ranging from the war in Ukraine to a disruption of established trade patterns with China and the U.S. are making regulators nervous again. Buch said banks relied too much on broad "overlays" - general provisions against new risks and uncertainty that cannot be easily captured by their internal models.
As examples, Buch said some banks used "umbrella overlays" which fail to account for how different sectors are affected to varying degrees by the same risk sectoral differences.
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Other banks simply lowered the general forecasts for economic growth that they use to calculate expected losses. "This ignores that for example a disruption of trade patterns may threaten some export-oriented clients while it might only marginally affect aggregate GDP," Buch, who has been at the helm of the ECB's Supervisory Board since the start of the year, added. "This practice underestimates the true default risks that banks are facing."
In addition, Buch said "many" banks failed to reclassify their loans appropriately, repeating a gripe often aired by her predecessor Andrea Enria. IFRS rules envisage three "stages" for loans - performing, underperforming and non-performing - based on how likely they are to go unpaid, resulting in rising levels of provisioning.
Good risk management in banks requires improving the use of overlays to consider the impact of novel risks more precisely, to use simulations and scenarios, and to improve stage transfers," Buch said.
