If a bank is not going to leave the business, it does not lose money on every loan.
The world’s accounting rule makers now advise the banks to post a loss every time they make a loan, because certain proportion of borrowed money unavoidably goes bad informs the New York Times.
However, such reporting of losses can entail serious consequences, because banks may use it to stop making loans having a difficult quarter.
For instance, it will help them to boost their profits, hurting the economy at the same time.
The rule can prevent financing, when it’s most needed to stimulate the economic recovery.
Still, last month the international board voted for such measures, starting from 2018. The rules should be implemented in more than a hundred of countries and being subject to ratification by various groups may be altered or postponed in some regions.
Why Rules are Backed by Many Investors and Regulators?
The answers to this question has its roots in the financial crisis and, besides, it’s determined by the fact that different countries apply similar rules in a different way, at present the rules are aimed to make banks increase loan loss reserves in the financial statements.
At resent the “incurred loss” model is used, adopted in the 1970s, most loans are worth the amount owed in the balance sheets of the bank. But when a loss incurred, the loans are written down to reflect it.
Still, there is an alternative which was also considered, it presupposed the estimation of lifetime losses, but instead of taking initial loss, the bank has to put the received interests on reserve for defaults, which may occur later.
Though the model was voted by two of the seven members of the board in America, the banks criticized it as too complicated and incomplete, as not always interests reserved could cover the loss. So the banks will show losses on loans in their books as soon as the ones are made.
International and American Approaches to Loan Loss Estimation aren’t Perfect
The international rule differs from the ones in the United States and turn out to be less severe.
The banks should estimate the potential loss for the initial 12 months of the loans which are outstanding and take a loss equal to that amount as soon as the loan is made.
In a year the loan is evaluated to define if showing the additional losses are needed.
American approach is likely to have more severe consequences in most parts of the world, especially in those ones where the loans have a tendency to have longer terms than in the USA and, consequently, much higher initial losses are presupposed as based on lifetime expected ones.
Walter P. Schuetze, a former member of FASB and a former chief accountant of the S.E.C., admits that both the new international rule and the projected American one cannot be effectively audited.
It was possible to play tricks with loss estimation, which has already been incurred, and it’s even easier now to play games with the expected loss definition based on the life of the loan.
Still, in the course of several years, banks will start reporting losses at the moment the loans are made.
There is some advantage for investors – the changes to the previous estimates will be visual to everybody, there is also a disadvantage that the banks will be able to manipulate their earnings regulating the number of unsecured online loans issued.