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The cyclicality of bank credit losses and capital ratios under expected loss model

Author

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  • Fatouh, Mahmoud

    (Bank of England)

  • Giansante, Simone

    (University of Palermo)

Abstract

We model the evolution of stylised bank loan portfolios to assess the impact of IFRS 9 and US GAAP expected loss model (ECL) on the cyclicality of loan write-off losses, loan loss provisions (LLPs) and capital ratios of banks, relative to the incurred loss model of IAS 39. We focus on the interaction between the changes in LLPs' charges (the flow channel) and stocks (the stock channel) under ECL. Our results show that, when GDP growth does not demonstrate high volatility, ECL model smooths the impact of credit losses on profits and capital resources, reducing the procyclicality of capital and leverage ratios, especially under US GAAP. However, when GDP growth is highly volatile, the large differences in lifetime probabilities of defaults (PDs) between booms and busts cause sharp increases in LLPs in deep downturns, as seen for US banks during the Covid-19 crisis. Volatile GDP growth makes capital and leverage ratios more procyclical, with sharper falls in both ratios in deep downturns under US GAAP, compared to IAS 39. IFRS 9 ECL demonstrates less sensitivity to lifetime PDs fluctuations due to the existence of loan stages, and hence can reduce the procyclicality of capital and leverage ratios, even when GDP is highly volatile.

Suggested Citation

  • Fatouh, Mahmoud & Giansante, Simone, 2023. "The cyclicality of bank credit losses and capital ratios under expected loss model," Bank of England working papers 1013, Bank of England.
    • Handle: RePEc:boe:boeewp:1013
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    More about this item

    Keywords

    IFRS 9; IAS 39; US GAAP; expected credit loss model; loan loss provisions; cyclicality of bank profits; leverage ratio; risk-weighted assets;
    All these keywords.

    JEL classification:

    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • L51 - Industrial Organization - - Regulation and Industrial Policy - - - Economics of Regulation

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