International Accounting Standards Board chairman Hans Hoogervorst said the IASB and the U.S. Financial Accounting Standards Board are making progress on an expected loss model for banking assets that will provide a more forward-looking model than the incurred loss model.

“Both the IASB and the FASB are convinced that we need a more forward-looking impairment model,” he said in a speech Monday at the 3rd European Central Bank Conference on Accounting, Financial Reporting and Corporate Governance for Central Banks in Frankfurt, Germany. “In fact we are well on our way to completing an expected loss model.”

The expected loss model would help banks deal better with the sovereign debt piling up on their balance sheets by encouraging them to write down the debt more quickly.

“From day 1, for all new financial assets, an allowance balance needs to be built up that captures the expected losses in the next 12 months,” said Hoogervorst. “If credit quality deteriorates subsequently to such an extent that it becomes at least reasonably possible that contractual cash flows may not be recoverable, lifetime losses need to be recognized. We will not try to define exactly what ‘reasonably possible’ means, but it primarily refers to the inflection point when the likelihood of cash shortfalls begins to increase at an accelerated rate as an asset deteriorates.”

Hoogervorst noted that to some degree, the expected loss model will rely on judgment, because it is not possible to predict with precision when the probability of default starts to accelerate.

“To arrive at this judgment, market indicators can and should play an important role,” he added. “So even for assets that are measured at amortized cost, fair value can contain very important information. Take the example of sovereign debt securities. If a sovereign’s debt is faced with clear sustainability issues, sinks below investment grade and suffers from double-digit market discounts, clearly there is a serious possibility that contractual cash flows will not be paid in full. A lifetime loss will probably need to be recognized, even if the securities in question are still being serviced. One just has to look at current market conditions to realize this model would lead to a much more timely recognition of losses than is currently the case.”

Hoogervorst acknowledged that while the expected loss model could help alleviate credit booms and busts, there is only so much accounting rules can do. Banks need to be better capitalized and rely on less leverage in their balance sheets.

“Unless bankers and their supervisors become a lot better at containing credit booms and their risks, busts with massive losses will periodically take place,” he said. “Even then, an expected loss model is preferable to an incurred loss model. But for an expected loss model to be applied rigorously, it is essential that banks are well capitalized. If such is not the case, even law-abiding banking supervisors might be tempted to buy time by condoning some stretching of accounting rules. Obviously, that is a temptation to which nobody should be exposed.”

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