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

journal contribution
posted on 2023-12-21, 09:52 authored by M Fatouh, S Giansante
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 doesn’t demonstrate high volatility, ECL model smooths the impact of credit losses on profits and capital resources, reducing the pro-cyclicality 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 pro-cyclical, 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 pro-cyclicality of capital and leverage ratios, even when GDP is highly volatile.

History

Author affiliation

School of Business, University of Leicester

Version

  • AM (Accepted Manuscript)

Published in

Annals of Operations Research

Volume

330

Issue

1-2

Pagination

807 - 840

Publisher

Springer Science and Business Media LLC

issn

0254-5330

eissn

1572-9338

Copyright date

2023

Available date

2024-08-11

Language

en

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