Loan Classification and Provisioning: A Few Latin American Issues

1
Loan Classification and Provisioning A Few
Latin American Issues

• Augusto de la Torre
• The World Bank
• Finance Forum
• June 20-22, 2002

2
Trends in the Prudential Approach

• Relaxing links between classification and
  provisioning
• Classification independent of collateral, not
  provisioning
• Classification of debtor, rather than of
  individual loans
• Corporate loan classification increasingly based
  on assessment of debtor capacity to pay (not just
  arrears)
• Different methods to classify housing consumer
  loans
• Generic provisioning requirement increasingly
  popular
• Explicit provisioning rules for repossessed
  collateral
• Requirements for more disaggregated reporting
• Special attention to restructured loans and
  micro loans
• Increasing emphasis on internal credit risk mgmt
  systems
• Embryonic in many countries, where on-site
  inspections are the credit risk management tool
  (!)

3
Procyclicality of Solvency Regulations

• One more item in prevailing procyclicality!
• Regulatory (credit risk-weighted) capital
  requirements a floor (not a cushion), invariant
  of the cycle
• Effect compounded by ill-designed exit
  frameworksincentives for widow dressing and
  forbearance
• Procyclicality of loan-loss provisioning regimes
• Results from under-provisioning in good times
• Fear to clean up (or the cost of virtue), due
  to adverse reaction of depositors to reported
  bank losses
• Bad loan burden is a drag on credit resumption
  (liquid banks that do not lend)

4
Countercyclical Provisioning Requirements

• Pioneering Spanish approach
• Problem to address good times are bad times for
  learning (Hausmann)
• Need to mitigate tendency to under-estimate
  expected losses, and make excessive dividend
  payments in good times
• The mechanics
• Counter-cyclical provisions, additional to
  specific and generic provisions, build out of
  income in buoyant times
• Converted into specific provisions, without
  affecting the income statement, as loans
  deteriorate in bad times
• Simple regulation pending development of internal
  models

5
Provisioning Rules and Credit Bureaus

• Supervisory-managed credit bureaus are common in
  LAC
• They offer great potential to enhance oversight
  via supervisory-managed systemic credit risk
  analysis
• But should banks be required to classify to the
  lowest denominator in the credit bureau?
• And should loan classifications by individual
  banks be disclosed through the credit bureau?
• The hot potato effect
• The follow-the-leader effect

6
Issues Raised by Financial DollarizationLoans to
the Non-Tradable Sector

• Specific problem debtors with incomes in the
  non-tradable sector have debts denominated in
  tradables
• More that just an issue of currency of
  denominationbalance sheet effects even under
  formal dollarization
• Fundamentally, loans to the non-tradable sector
  carry special risk with financial dollarization
• Risks not internalized by banks in buoyant times
• Need to design specific classification and
  provisioning norms for loan exposures to
  non-tradable sector
• Counter-cyclical system, a la Spain, seems
  appropriate

7
Issues Raised by Financial DollarizationExposure
to Government Credit Risk

• A silver lining of financial dollarization
  fiscal and banking system solvency can be in
  principle de-linked
• Store of value that organizes financial
  intemediation is not issued at home
• Panama, Ecuador
• Potential could be harnessed through prudential
  norms, including appropriate valuation of claims
  on government
• Complex issues of timing and feasibility