Wednesday, March 7, 2018

Since the 2009 G20 Pittsburgh Summit, pro-cyclicality has rightly been a prominent concern within the regulatory community. Some particular initiatives, such as the counter-cyclical capital buffer and the use of supervisory stress testing to inform capital buffers, have helped target this issue. However, we are concerned that the introduction of IFRS 9, based on expected loss (EL), could cause greater capital volatility and bring unintended consequences, compounding the sensitivity of the current risk-weighted asset (RWA) framework during a downturn period.

Consequently, to illustratively demonstrate the pro-cyclical implications of the new accounting requirements compounded with the current RWA framework under a downturn scenario, we have modelled the Common Equity Tier 1 (CET1) capital ratio impacts across different bank balance sheet scenarios, and under Internal Ratings-Based (IRB) Approach and the Standardized Approach (SA) for each of:

(i) IFRS 9 estimates in a benign (e.g. current) environment; and
(ii) IFRS 9 and RWA inflation estimates in a stressed environment.

Based on our IRB and SA bank stress scenario, we find IFRS 9 provisioning can erode CET1 between ~70-120bps, while RWA inflation can erode CET1 between ~40-150bps. When aggregating both impacts, this has a doubling effect in CET1 erosion. The absence of capital relief provided under the regulatory framework for holding a higher level of provisions, will add pressure to banks’ CET1 ratios in a stressed environment. This can in turn lead to a tightening in credit availability, prolonging a downturn.

While it is stressed that the portfolio impacts and responses of each firm will differ, this representative analysis highlights the critical need for policy makers to carefully consider the loss-absorption capacity of the additional provisions, as well as the inherent ratings cyclicality in the capital framework.

IIF Authors

Brad Carr

Senior Director, Digital Finance Regulation and Policy

Hassan Haddou

Policy Advisor