A high variance in expected credit loss disclosures across institutions makes it hard for analysts to gauge credit risk in European bank portfolios.
Changes in the economic and market environments in recent years have laid bare the limitations of expected credit loss (ECL) models adopted under the IFRS 9 accounting standard in early 2018. COVID-19 and the war in Ukraine mean key indicators, such as inflation, have broken away from historic patterns the ECL models rely on, pushing banks to apply greater management judgment to compensate for the shortcomings.
Adjusting to the changing environment is crucial to ensuring banks have sufficient provisions to cover potential losses, yet management judgment makes ECL estimates hard to understand and compare, credit analysts and accounting experts said. Without transparency and consistency of ECL disclosures across the sector, investors and analysts would struggle to assess how well a bank is handling a downturn, they said.
"The standardization of disclosures is the key issue here," said Alain Laurin, associate managing director in credit rating agency Moody's financial institutions group. "Even if banks are more transparent about their ECL models, comparability will still be a challenge if transparency is understood differently at different banks," Laurin said.
Surging inflation and rapid interest rate hikes are increasing pressure on borrowers, making asset quality a key concern for banks. Most large European banks are projected to book higher nonperforming asset (NPA) ratios for 2023 versus the prior year, and many will record further asset quality deterioration in 2024, S&P Global Market Intelligence data shows.
Lack of clarity
Levels of loan loss provisions — the funds banks set aside every quarter or half-year to cover potential future losses — vary widely across the largest banks in Europe, the data shows.
The same is true of loan loss reserves, which represent the aggregate amount of provisions made over a longer period of time. Reserves change with each periodic charge or release of provisions.
Furthermore, there is little correlation between asset quality and level of funding banks set aside to cover riskier loans. Nordic banks Nordea Bank Abp and Skandinaviska Enskilda Banken AB (publ) hold the highest reserves as a share of problem loans while having some of the lowest problem loan ratios among the largest European banks.
Spanish bank Banco Santander SA, meanwhile, shows the highest bad loan ratio but holds lower reserves than many of its peers. Santander's credit quality remains robust, with cost of risk "well under control," CFO Jose Antonio Garcia-Cantera said during a first-quarter earnings call. The ratio of bad loans has improved year over year, he said.
Asset quality implications
While "broadly helpful" for assessing asset quality, the ECL approach could lead to differences in loan loss provisions across banks that are "not purely attributable to differences in asset quality," S&P Global Ratings said.
One of the key drivers of the inconsistencies is the management judgment banks apply when deciding when to categorize loans as Stage 2, or underperforming, said Osman Sattar, accounting specialist in S&P Global Ratings' EMEA financial institutions team.
Under IFRS 9, Stage 1 are considered performing loans, Stage 2 are loans where there has been a significant increase in credit risk since initial recognition, and Stage 3 refers to nonperforming loans. A shift to Stage 2 would result in a surge in costs because it requires the bank to provision for the lifetime ECL of the loans rather than the 12 months required in Stage 1.
Banks have discretion in setting the triggers for the transfer of loans to Stage 2 from Stage 1, leading to variability and limited comparability in provision levels, said Sattar.
Stage 2 loan levels as of the first quarter increased year over year at most of Europe's largest banks, with UK-based NatWest Group PLC, Belgium's KBC Group NV and Sweden's Handelsbanken showing the biggest growth, Market Intelligence data shows. Quarter-over-quarter results are divergent across the sample.
More detailed disclosures on the quantitative metrics used to trigger Stage 2 transfers would allow investors and the wider market to better understand what drives the differences in provision levels, Sattar said.
A review of recent annual and quarterly reports of the 24 major European banks in the Market Intelligence sample shows wide variability in the format and granularity of disclosures on quantitative Stage 2 triggers. Dutch lender ABN AMRO Bank NV stands out, with extensive details provided on transfer triggers and a graphic showing when and why loans are moved across IFRS 9 stages. Most other lenders stick to shorter, non-numerical descriptions of the triggers.
Model adjustments
Another cause of divergence in provisions is the large overlays and model adjustments many banks made to mitigate risks emerging from economic turbulence in recent years that models could not capture due to a lack of historic data.
"It has been an awfully long time since we have seen an environment with rising interest rates, high inflation, and rising unemployment," said Richard Tedder, partner and credit risk team lead in Deloitte's audit and assurance function. Until new data reflecting the changed landscape emerges banks must apply management judgment to compensate for current risks, Tedder said.
Banks should be clear about the conditions of putting an overlay in place and for removing it, Tedder said. For example, if the reason for the overlay is high inflation, a condition for its release would be the normalization of the inflation rate.
Few banks in the Market Intelligence sample provide separate amounts for overlays based on the type of risk and set conditions for the overlays' release, the review of financial reports showed. Most tend to report an overall amount listing several factors driving the post-model adjustment.
The ECB said in May that overlays should be "grounded in sound analysis with strong governance and transparency," warning there is cause for concern if these "not implemented properly." The central bank said the wide variability across banks was surprising, with overlays in provisions for Stage 1 and Stage 2 loans ranging from zero to 70% at the 51 lenders that responded to a recent survey.
The share of overlays in expected credit losses across EU banks in the first quarter ranged from zero to 40%, European Banking Authority data released July 13 shows.
UK example
Large UK banks likely have some of the best ECL disclosures globally thanks to recommendations the Taskforce on Disclosures about Expected Credit Losses (DECL) issued, Tedder said.
The taskforce's guidance, which includes specific requirements around disclosing post-model adjustments, was developed through dialogue among the seven largest UK banks, and sell-side and buy-side analysts. Involving the analyst community was important as banks could get feedback from the main users of their IFRS 9 accounts, Tedder said.
UK banks in the Market Intelligence sample disclose the full economic scenarios that shape their ECL calculations and the weighting of each scenario in the estimates. The format and granularity of UK bank disclosures is more consistent than those of banks in other regions, but still varies across institutions. Standard Chartered PLC stands out, reporting overlay amounts for specific portfolio risks separately.
Most major Nordic and Benelux banks also provide more details on provisions and overlays, but there is no consistent format or granularity of disclosures across institutions, even in the same market.
All top seven UK banks have committed to following the common set of disclosure recommendations, which the taskforce regularly updates. While only the big UK banks are involved, the initiative would likely trickle down as smaller banks often try to follow industry best practices, Tedder noted.
"Providing more comparable and more granular information … will help banks produce ECL disclosures that are more useful to users," KPMG UK associate partner Silvie Koppes said in a post following the taskforce's latest updated guidance in September 2022.