The international banking crisis has drawn favourable attention to the system of dynamic provisioning for credit losses adopted by Spanish banks.  Jesús Saurina describes how it is operated and calls for the practice to be fully accommodated in the current accounting framework 

With the benefit of hindsight, what we have seen in the run-up to the current crisis is a substantial under-pricing of risks being built up in the banks’ books. This has come about as a result of over-optimism among borrowers and lenders, fuelled by abundant liquidity and an intense search for yield in a low-interest-rate environment. 

The credit risk increase was not properly recognised in banks’ financial statements. In general, profits and dividends reached record levels year-after-year, as did management remuneration based on them. Yet the rampant risk-taking was making an increase in loan losses inevitable. 

It now seems clear that financial statements delivered by banks did not properly recognise the substantial increase in losses that were certain to be incurred but had not yet been identified in specific loans. Either bank managers did not exercise enough judgment to increase loan loss provisions, or accounting standards were not sufficiently flexible to allow coverage of those inevitable losses. 

Dynamic provisions are a way to cover losses not yet individually identified on specific loans as these losses are being built up in balance sheets, and to deliver accurate information to investors about the financial position and risk profile of the firm. A profit and loss account that only informs of the increase in income generated but is mute on the risks/losses incurred to obtain that income provides the wrong incentives to management: keep increasing the leverage (i.e. strong credit growth), on and off balance sheet, at a time when over-optimism, strong competition and under-pricing of risk dominate the financial landscape. 

Since mid-2000, Spain has applied a dynamic provisioning system (so-called statistical provision), which was revised in 2004 to be consistent with the incoming International Financial Reporting Standards (IFRS). 

Dynamic provisions refer to the collective assessment for impairment, and are based on historical credit loss information from the Banco de España Credit Register, a database at individual loan level. Our dynamic statistical, or general, provision is not an expected-loss model, but rather, a backward-looking model. These losses are effectively incurred.

It is a rule-based system, but there is nothing to prevent each bank from applying its own loan-loss model to calculate provisions. 

One key element of dynamic provisioning is that it recognises that the speed of transition from losses incurred but not yet individually identified to specific individual loan losses varies according to the point in the lending cycle. In expansion periods, the transition is very slow, while in downturns it is very fast. 

To put it into operation, we have two parameters (alpha and beta). The alpha parameter is the average estimate of the credit loss, or the collective assessment for impairment in a cyclically neutral year. It is tailored to homogeneous loan portfolios (i.e. different alphas for credit cards, mortgages, loans for small and medium enterprises, etc.). 

The beta parameter is the average specific provision for those loan portfolios. By comparing the current level of specific provisions with that average, we recognise the different speed at which collective assessment for impairment translates into specific losses. 

In addition, we have a cap in the dynamic provision fund to avoid excess provisioning and the system is transparent. Banks must disclose separately the amount of dynamic provision, so that investors have all the relevant information. A transparent rule-based system with a cap kills any suspicion that it may be used by bankers to manage/smooth their results (no room for cookie jars). 

Since dynamic provisions accurately register credit losses already incurred, they must be above the bottom line in the P&L account. This is the only way to deliver correct information to investors about the true financial position of the bank as well as the right incentives to management. 

Dynamic provisions account for about 10 per cent of the net operating income of banks. At the end of 2007, before they started to be drawn down, they covered around 1.3 per cent of the total assets of Spanish deposit institutions. General provisions are tax deductible up to 1 per cent of the increase in normal loans, provided they are not mortgages. Non-deductible amounts are accounted for as deferred tax assets, which will become deductible, when the impairment is assigned to an individual loan. 

Dynamic provisions are an accounting device with a macro-prudential dimension. As banks properly recognise the losses incurred through the lending cycle, they are building up a (transparent) buffer that protects them when credit losses appear in specific loans. Moreover, they make managers (and investors) more aware of the credit risk incurred and can, therefore, contribute to a more prudent appraisal of lending. Finally, by addressing the bias in profits during expansion, they may help to curtail the incentives for management to increase leverage.  Of course, there is no guarantee that the amounts provisioned will be enough to cover all the individual credit losses banks are facing, given the depth of the current crisis. 

Nevertheless, dynamic provisions have contributed to the stability of the Spanish financial system and allowed Spanish banks to cope with the crisis from a much better starting point.

To conclude, there is an urgent need for an enhanced dialogue between bank supervisors and accounting standard setters to explore how dynamic provisions can be fully accommodated in the current accounting framework. This will not help us to get out of the crisis but it will certainly reduce the depth of the next one. Now is the right time to make the necessary changes.

Jesús Saurina is Director of the Financial Stability Department at Banco de España - the opinions expressed in this article are his own

Published by kind permission of Financial World magazine www.financialworld.co.uk