Comment: Debate over the return of dynamic provisioning
Some banks have expressed a desire for Basel III capital requirements to be reduced, to the extent that implementation of IFRS 9 results in increased provisions for credit losses.In January 2018 the international accounting standard on provisioning, IAS 39, will be replaced by IFRS 9, signalling a move from the recognition of actual losses to a from of dynamic provisioning that recognises losses through the economic cycle.It may be more of an international issue, where different regulators may apply different definitions of capital, but the correct view of the situation is that provisions made for credit losses count as core equity tier one capital, thus no adjustment should be required for the amount of CET1 that a bank should have.Indeed, the use of credit loss provisions to meet CET1 requirements, takes the pressure off shareholders to tip in more equity. Dynamic provisioning was a term introduced to Australian banking in 1990s when Westpac chief executive Bob Joss introduced the process. Dynamic provisioning is a recognition that in buoyant economic conditions provision should be made for the credit losses that will inevitably be incurred when economic conditions turned down. When the economic cycle turned up again, any provision in excess of future requirements could be written back through the profit and loss account. This approach had the beneficial impact of easing the volatility of earnings that would otherwise result when recognition of credit losses was delayed until unavoidable.Introduction of dynamic provisioning followed the near death experience of Westpac in the early 1990s, when the continuing viability of the bank came into question after massive losses were incurred from the bank's commercial property exposures. The losses were the result of the exuberant lending practices of the late 1980s that were exposed in the 'recession we had to have'.The introduction of dynamic provision at Westpac, was quickly taken up by other banks and became a standard practice across the industry. It was popular because it did indeed have the advantage of reducing volatility in reported earnings.Through judicious adjustments to a bank's level of general credit provisions, earnings could be smoothed from one year to the next. This was a process that shareholders favoured but one that accounting bodies eventually decided was inappropriate.The Australian version of the accounting standard IAS 39 was introduced in 2006, putting an end to dynamic provisioning.The view of the accounting bodies was that loss recognition should be restricted to identifiable assets and delayed until a 'trigger event' occurred. General provisions could still be made but again there needed to be a tangible, identifiable event that would provide the rationale for increasing the provision.However, the GFC exposed the weaknesses of this approach. Delaying the recognition of losses actually resulted in companies 'postponing losses'. IAS 39 used many complex impairment models for financial instruments, which served to encourage delay of loss recognition.As a result, IAS 39 is to be replaced, from 1 January 2018, by IFRS 9. The main objective of IFRS 9 is to provide users of financial statements with