Timely classification and measurement of credit risk are critical for banks to provide confidence to supervisors and their stakeholders on their financial health.
Delaying loss recognition on deferred loan payments too long may leave banks and supervisors with fewer options for dealing with future risks to the banking system, says a new paper from the Financial Stability Institute.
As outlined in the paper, Australia, Canada, Hong Kong, Italy, Singapore, South Africa, Spain, the UK and the US are among the jurisdictions that have implemented payment deferral programmes.
These programmes provide an “indispensable lifeline to consumers and businesses affected by Covid-19, but they could also increase future risks to the banking system,” it says.
As such, the design of such programmes will be critical in balancing the short-term needs of borrowers with longer-term financial stability considerations, trade-offs outlined in the paper:
For example, a legislative moratorium with flexible eligibility criteria may deliver maximum near-term relief while increasing banks’ exposure to credit risk. On the other hand, when public guarantees are used in combination with legally mandated payment deferrals, the reduced discretion of banks to select eligible borrowers is at least partially offset by the government guarantee. Finally, the length of the grace period may be a relevant risk driver, particularly if both principal and interest payments are suspended. In this situation, loan balances will grow over time, owing to the negative amortisation from the deferral of interest payments, increasing risks for borrowers and banks.
The financial stability implications of payment deferral programmes will be driven by the extent to which borrowers will be able and willing to repay their debt obligations once the payment holidays expire, particularly in the absence of a public guarantee, the paper says.
Yet, prudential authorities are caught “between a rock and a hard place” as they encourage banks to provide credit to solvent but cash-strapped borrowers and allow flexible approaches on the treatment of payment deferrals under IFRS 9 accounting methodologies, aware of the longer-term implications these measures may have on the health of banks and national banking systems.
“The cumulative impact of Covid-19 and payment deferral programmes on bank balance sheets depends on many factors and will only become apparent over time,” the paper says. “Therefore, the timely classification and measurement of credit risk is critical for banks to provide confidence to supervisors and their stakeholders on their financial health.”
“Delaying loss recognition until the tide goes out may leave banks and supervisors with fewer options for dealing with the repercussions.”
The full paper is available here.
The paper was written by Financial Stability Institute senior advisors Rodrigo Coelho and Raihan Zamil.