RDP 2015-06: Credit Losses at Australian Banks: 1980–2013 Appendix A: More Accounting

A.1 Credit Losses

Banks' financial reports provide a number of different items which capture credit losses:

1. Net charge to profit and loss account for individual provisions: For most loans, when a bank identifies that it has incurred a loss on the loan, it must raise an individual provision (a liability) in order to reduce the carrying value of the loan to the amount it expects to recover. This reduction in net assets is a loss and must be recognised as an expense to the profit and loss account. The net charge incorporates the release of individual provisions held against loans that no longer require them (because, for example, a borrower has recommenced making repayments).
2. Net charge to profit and loss for collective provisions: Similar to 1, but collective provisions are held against incurred losses on loan portfolios with similar characteristics (usually retail loans that are too small to deal with individually), and the losses historical experience suggests are likely on the portfolio of currently healthy loans (to an extent, see Appendix B).
3. Transfers from collective provisions to individual provisions: Some banks fund all provisions through collective provisions at first. When losses on individual loans are identified, appropriate amounts are transferred from collective provisions to individual provisions to cover these losses, and an amount necessary to replenish the collective provision to appropriate levels is charged to the profit and loss though item 2.
4. Write-offs and recoveries to individual provisions: Write-offs are the final step of removing troubled assets from the balance sheet, and, for larger loans, are made after losses have been recognised through individual provisions and recoveries of any collateral made. The troubled loan, individual provision and amount recovered should cancel out so that there is no impact on the profit and loss account at this stage.
5. Write-offs and recoveries to collective provisions: Loans that have been collectively provisioned for are written off against collective provisions.
6. Write-offs and recoveries direct to profit and loss: Loans where there is no prospect of recovery can be written off immediately upon evidence of loss emerging. As there are no provisions held against such assets, their write-off has an impact upon the profit and loss account. This category sometimes also captures losses on loans that are not adequately covered by existing provisions.
7. Charge for bad and doubtful debts: The total charge to the profit and loss for credit losses: the sum of 1, 2 and 6. The charge for bad and doubtful debts is the net reduction in the value of a bank's assets due to credit losses in a given period. It appears in a bank's profit and loss account and so is a component of the net change in a bank's capital position over each period.

Unlike the charge for bad and doubtful debts, the other two aggregate measures of credit losses used in this paper, net write-offs and current losses, are not calculated in banks' financial reports. Net write-offs are the sum of 4, 5 and 6; current losses are the sum of 1, 3, 5 and 6.

A.2 Non-performing Assets

‘Performing’ and ‘non-performing’ are a classifications applied to the assets banks hold at amortised cost (mainly loans and some other credit-type assets). These terms are, in most countries, defined by accounting standards and rules set by banking regulators. In Australia, NPAs include two categories:

• Past-due assets are those where repayment is 90+ days in arrears, but which are covered by sufficient collateral such that no loss is expected (well-secured).
• Impaired assets are those where repayment is 90+ days in arrears or otherwise is doubtful and which are not well-secured.

A.3 An Example

The accounting surrounding credit losses, and the relationship between NPAs and credit losses (and profitability and capital), can be illustrated via the souring of a hypothetical $200 million loan to a commercial property development company (see Figure A1):

1. At December 2007 the loan was being repaid on time and was otherwise within its conditions.
2. During early 2008, pre-sales of residential units within the development began to dry up. As a result, the borrower (a property developer) began to run out of cash. It was unable to meet its required loan repayment in January 2008, and also failed to make required repayments in February and March.
3. In accordance with prudential standards, immediately upon aggregate loan arrears reaching 90 days of repayments (in April), the bank assessed its expected future cash flows from the loan. It ascertained that the developer company was in poor financial shape and would be unable to complete the development. The bank thus decided that the sole loan recoveries likely to be made were those from exercising its rights to repossess and sell the unfinished development (the security for the loan). The bank assessed the market value of the development as $100 million, and thus classified the loan as impaired and raised an individual provision of $100 million against it. This was funded through a charge to the bank's profit and loss account (item 1 in Section A.1).
4. The unfinished development did not attract any offers to buy it over the remainder of 2008. At the end of the year, the bank decided that property market conditions had deteriorated, and had the property re-valued. The valuation this time came to $50 million, so the bank increased its individual provision against the loan by $50 million, again funded through a charge to the profit and loss account.
5. In March 2009, the property sold for $50 million. The bank received this amount and wrote-off the $200 million loan and $150 million individual provision (with no impact upon the profit and loss account). The write-off of individual provisions is item 4 above.
6. In June 2009, the liquidation of the development company was completed. In the final distribution of assets to its creditors, the bank unexpectedly received $10 million. The bank acknowledged this amount via a recovery direct to profit and loss, which reduced both the cumulative charge for bad and doubtful debts and cumulative net write-offs from the loan to $140 million. This is the net impact on the bank's profitability and capital of the credit losses caused by the non-repayment of this loan.

This example closely follows how banks have actually dealt with troubled loans over recent years, but there are ways in which the bank could have managed the loan that would have led to different relationships between NPAs and credit losses. For example, the bank could have immediately sold the development for the best available price and written off the necessary amount against its profit and loss account, without ever raising any provisions. Alternatively, the bank could have kept the impaired loan on its books and delayed sale of the development (perhaps for several years) until the market recovered sufficiently to allow a higher sale price. A different asset type could also have changed the relationship: if the asset in question was $200 million worth of residential mortgages, which are normally much better-collateralised, the time profile for NPAs may have been exactly the same (except made up by past-due, rather than impaired, assets) but credit losses to the bank may have been much lower.