An Approach to Measuring Provisions for Collateralised Lending

Under the framework of Basel II, banks which adopt the internal ratings-based approach will be required to compare their actual provisions with expected losses. Any shortfall (i.e., the expected loss exceeds the provision) should be deducted from capital of the bank. It is therefore important to ensure banks make adequate provisions against expected losses. In addition, both sound policy and the Banking Ordinance require banks to take a forward-looking view of provisions. These requirements raise the issue of how to determine an adequate level of provisions in response to changing market conditions, in particular requiring adequate provisions from an expected-loss perspective. The purpose of this paper is to employ a simple model for measuring provisions for collateralised loans. The collateral value and the probabilities of default (PD) of borrowers are the two correlated input variables in the model. The model incorporates forward-looking elements including volatility of the collateral value and correlation between the collateral value and the PD into the measured provisions. The model can be readily extended to measuring provisions for loans without collateral provided that the expected values and volatility of the loans' recovery rates can be estimated. Some calculations of provisions with different loan-to-value ratios and one-year PD are presented for illustrative purposes. For example, using the classified-loan ratio of 1.49% as at September 2005 as a proxy of the PD and the loan-to-value ratio of 180% (which corresponds to the loss-given-default of about 45%), the provision for loans is about 0.66% of the outstanding loan value. Promotion of forward-looking provisions in assessments of risk can obviate the need for large increases in provisions when the economy is in recession. This means that procyclicality of lending would be reduced to some extent.