New accounting standard on loan-loss provisions to dent bank profits

• To make capital ratios difficult

Sri Lanka’s banks are expected to face a yet another challenge, this time from a new accounting standard, which came into effect on January 1, 2018. 
The new International Financial Reporting Standard 9 issued on financial instruments will increase the provisions against the possible loan losses and compress margins exerting pressure on the bottom line and thereby the regulatory capital, the banks said. 

Commercial Bank of Ceylon PLC (ComBank), Sri Lanka’s largest private sector lender by assets, said the change in the accounting methodology in classification and measurement of the possible loan losses under the new standard, would lead to higher impairment provisions by banks.  

“Adoption of the ‘expected loss model’ in place of the ‘incurred loss model’ for impairment testing upon implementation of SLFRS 9 is expected to substantially increase the impairment provision of banks,” ComBank said in its annual report. 

Sri Lanka fully adopted IFRSs in their original form in financial reporting and thus all international accounting standards are also identified as Sri Lanka Financial Reporting Standards, in their identical form.  

The provisions against possible bad loans have tended to be more subjective estimates based on management judgments and these provisions could be used to manipulate profits to show a better financial performance across different reporting periods.

There was a case in the latest financial reports of one of the leading banks where it had reported a hefty collective impairment provision reversal although its asset book had grown.  

SLFRS 9 appears to have reduced these management biases as the new standard requires the bank to recognize the 12-month expected credit loss although the loan had not exhibited a significant deterioration in the asset quality.   

But for other facilities of which the credit quality has significantly deteriorated since the initial recognition of the loan, the bank is required to make a ‘life-time expected credit loss’ against the loan. Both cases lead to higher impairment provisions against loans leading to lower profits and direct impact on the banks’ Tier I ratios under Basel III, Pan Asia Bank said. 

“The implementation of this standard from January 1, 2018 onwards is widely expected to increase the stock of credit impairment provisions and affect profits adversely. As a result, many banks are expected to suffer a decline in regulatory capital,” ComBank said. 

The bank also said the new standard would dent its margins leaving it with limited profits, which could otherwise be capitalized. 

“The implementation of the SLFRS 9 impairment model puts extra pressure on the already dwindling NIM of banks and eventually the ability to plough back profits as capital for future expansion purposes, with the shift to the ‘expected credit loss’ model,” ComBank added.

The Sri Lankan banks, particularly the small and mid-sized banks, are facing a tough time to make higher profits and raise significantly higher capital – mainly equity – to meet the steeper increase in minimum capital ratios stipulated by Basel III when the new rules come into full effect by January 1, 2019.

Under Basel III, the biggest challenge faced by the banks is that a large section of those new capital raised will stay idle as shock buffers and will have a tough time in giving value to shareholders measured by the return on equity (RoE). 

Unless the banks look attractive in their RoEs against their other industry players, the banks will have an uphill task in raising fresh capital from the stock owners. 
Since the full adoption of International Financial Reporting Standards, Sri Lankan firms are required to change their financial reporting according to the changes in those standards.