In Switzerland, the national Swiss Financial Market Supervisory Authority (FINMA) has the authority from the Federal Council to set accounting standards for financial institutions with a focus on the technical aspects. In November 2019, FINMA proposed a revision to the standards regarding the provisioning for counterparty default risks. This proposed update has later been referred to as the FINMA Circular 20/01 “Accounting – Banks”, and was intended to update the existing Circular for banks at that time to advise on the new FINMA Accounting Ordinance. The Accounting Ordinance and the Circular were entered into force on 1 January 2020.
Why did things need to change?
A particular risk that requires a lot of attention to traditional banks is the default risks incurred when granting loans. These risks are reflected through value adjustments. Previously, regulations were focused on specific allowances for uncertain debts as well as forming value adjustments for latent default risks.
Under FINMA’s definitions, a latent default risk is known to occur within a seemingly perfect credit portfolio on the balance sheet date and only becomes apparent in a later stage, similar to the concept of incurred-but-not-reported losses in the former IFRS standard IAS39.
The provisions on the impaired receivables are a so-called incurred-loss approach since a value adjustment will only be made when a certain loss event has occurred. However, this incurred-loss approach has been criticized after the 2007 financial crisis, due to its ‘too-little-too-late-problem’, as banks established it both too late and in a too limited extent. FINMA foresaw a well-needed adjustment but suspended this as international developments by both the IFRS and US GAAP were being made toward methods in recognizing expected credit losses.
The international standards, IFRS and US GAAP, have made a fundamental change concerning the approach in calculating the loan loss provisions by introducing an Expected Credit Loss (ECL) Approach. For all banks in Switzerland who apply either IFRS or US GAAP must implement the respective ECL approach in their national accounting standards.
By publishing the Circular, it could be shown that FINMA considered certain deficiencies in the previous accounting regulations, and therefore, suggested some necessary improvements. Consequently, FINMA had its main interest in early identification of credit losses to mitigate the pro-cyclical effects. The Financial Stability Forum already emphasized the importance of this in their report on addressing pro-cyclicality in the Financial System: “Earlier identification of credit losses is consistent both with providing financial statement users transparency into changes in credit trends and regulators with the prudential objectives of safety and soundness”.
Categorization of banks
In Switzerland, FINMA has established a 5-category classification system for banks. It assigns all supervised banks (and securities dealers) to certain supervisory categories. The key outlines of each category are as follows:
- Category 1: extremely large, systematic important and complex banks (UBS and Credit Suisse);
- Category 2: very important, complex banks (Vontobel, Raiffeisen, and Zürcher Kantonalbank);
- Category 3: large and complex banks (larger cantonal banks);
- Category 4: medium-sized banks (smaller cantonal banks);
- Category 5: small banks (other small firms).
FINMA proposed a proportionate approach based on the categorization of banks, which would avoid any unnecessary complexity in identifying default risks. FINMA, therefore, did not introduce the ECL Approach for category 3, 4 and 5 banks. As systematic important banks follow international accounting standards, they, consequently, have to follow the ECL Approach. On the other hand, this Circular has been of great importance to category 3 banks, who are primarily active in the interest rate business. Banks in this category are now urged to identify value adjustments for inherent default risks. Which approach they will use is up to the bank itself. Consequently, banks that had already established an estimation of the latent default risks were, in general, able to continue doing this.
A proportionate approach
The core of the proposed approach by FINMA has been within its proportionate method, where separate regulations come in place to the different banking categories that are active in Switzerland.
First, the category 1 banks, who use an acknowledged international accounting standard in their consolidated financial statements. These banks are still obliged to make us of the ECL Approach to identify the correct value adjustments concerning default risks. As this approach was already being used, these banks did not need to consider any additional or alternative inherent default risk recognition methods.
Under FINMA’s definitions, an inherent default risks is a risk that experience shows to be present in a credit portfolio on a specific valuation date and that, however, cannot be allocated to a particular borrower or receivable.
"The international standards, IFRS and US GAAP, have made a fundamental change concerning the approach in calculating the loan loss provisions by introducing an Expected Credit Loss (ECL) Approach."
A similar structure is needed to be in place for category 2 banks. They now use a proportional ECL Approach based on both long-term average estimates and a remaining maturity outlook. This method involves a model-based approach where the probability of default (PD), the loss given default (LGD) and the exposure at default (EAD) are separately computed for all stocks for which the Internal Ratings Based (IRB) Approach has to be used in regulatory terms. For the residual stocks, where the Standardized Approach is considered, a simple ECL Approach can be used. The determination of the remaining maturity can be constructed with simple assumptions (e.g. average maturity of the portfolio).
Category 3 banks, with a core business in the interest rate differentiation, now need to identify value adjustments for inherent default risks. Latent default risks are a significant part of the possible inherent default risks that can occur. Whether a bank is primarily active in the interest rate differentiating business is captured in requirements from the FINMA Circular 19/2 “Interest-rate risks – Banks”.
The banks themselves determine the method for computing the value adjustments for inherent default risks. Through this procedure, every category 3 bank is allowed to further use their method of value adjustment for latent default risks, by improving it under a new name. Much freedom is accepted here, however, complete transparency is required by reporting clear explanations within the appendices. Additionally, all methods, data, and information that has been used need to be documented in a comprehensible and explicit manner.
Under the previous regulations both the banks in the remaining categories, 4 and 5, and securities houses needed to consider the latent risks as the default risks that needed value adjustment. Therefore, they did not have to make specific value adjustment for inherent default risks but still needed to correctly assess the latent default risks. These risks will now be regulated more strictly according to the applied regulations, where a more disclosed reporting is required. Institutions that already implemented an extensive method in establishing latent default risks, could continue to carry on doing this. Additionally, in case a bank wishes to pursue further risk provisioning, it can optionally use an approach to recognize value adjustments of a higher banking category.
Sticking to the previous provisioning approach has not been an option for most category 2 and category 3 banks. However, FINMA rejected the strict approach of introducing the complex ECL Approach for all banks, so instead, a more pragmatic solution had been proposed based on proportionality. This solution was found to be easier to implement for all banking categories and considered the important conditions within the banking sector. This approach beholds a differentiation in loan loss provisioning between the different banking categories, which could potentially complicate the comparability of the financial statements. However, this has been taken care of by useful disclosure requirements. Although there are some drawbacks to the new approach, it provides a better incentive for smaller banks to make some important improvements within their financial reporting framework concerning the estimation of inherent default risks.