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Expected Credit Losses Vs Incurred Credit Losses

|Includes:DFS, FNMA, HDB, IBN, JPMorgan Chase & Co. (JPM), WFC

The proposed FASB standard on Expected Current losses is an improvement to the current accounting standard on Probable losses.

Bank's provides loans to various borrowers and it is very difficult for the investors to know the quality of the assets on Bank's balance sheet. One can look at the current losses or the past losses, but one does not know about the quality of the assets that are currently sitting on the bank's balance sheet. Retail assets' losses at any point in time are function of four main factors viz- Lifecycle (Time since origination of loan), strength of the borrower, collateral and economic environment.

Different types of loans have different lifecycles. Vintage analysis tells that credit card delinquencies peak in 1-2 years, mortgage delinquencies peak in 3-4 years etc. After the financial crises, banks started disclosing vintage of the loans, as investors demanded these disclosures. There are no disclosure rules for vintage analysis of the loans.

The factors affecting borrower strength like credit score, debt to income ratio, types of collateral held by bank are not known to the investors. The losses incurred by a bank also are a function of the strength of the borrower. Higher credit score, lower debt to income ratio leads to less losses, all things equal. Disclosures about the characteristics of the borrower will help investors in comparing different banks about the asset quality held by banks. It will help in knowing the adequacy of loss allowances, by comparing the allowances of different banks.

The economic environment affects the expected losses. The proposed rules require that banks update the expected losses based on the forecast about the economy. If investors have a different view about the economy, can update their view of the expected losses based on their analysis of the economy. This will be complex issue for both the both the Management of the bank and for investors. Often there is uncertainty about the economic forecast. Knowing what forecast Management of the banks have used in assessing the allowance for the loans, will give investors to make their own assessment of the forecast for allowances.

Value of the collateral affects the recoverability of the loan. Unsecured loans would have higher losses as there is no collateral that can be seized by the bank and sold for recovering the loan. There are no rules for disclosure of the collateral held by the bank.

Credit losses for Loans issued during the economic growth environment are less and lenders typically relax the lending standards. Investors are not able to know how much standards have been relaxed. The existing book of business may be different from the past book of business and therefore the investors don't know about the quality of assets..

By requiring Management of the Bank to explicitly book losses based on their view of expected losses, investors will have additional insight about the current quality of the assets held by the bank. Managements have a view of the losses through the credit cycle, however based on current disclosures, Investors cannot form the view. Banks have advanced analytics to decompose the credit losses into various factors mentioned above.

There will always be differences how different financial institutions calculate the expected losses. Some of the differences will be due to modeling difference between the institutions and some of them will be due to differences in financial institution's Management view about the future. For example if two credit card companies come up with very two different numbers for the expected losses, investors will question the Management of the companies about the various assumptions. This process of inquiry will either convince the market that one credit card Company's portfolio is more risky to another or bring out the fact one company's management think that economy is deteriorating and it warrants more expected losses. This kind of review of the assumptions will give investors more insight into the quality of earnings. If one institution is earning higher return by taking additional risk, this additional risk may be highlighted with the proposed rules, as that institution will have to book higher allowance based on additional risk taken by it.

As the Recession grew deeper, many people working inside the financial institutions knew that some of the loans that are on their books will have much higher losses, but they could not book the losses as they were not probable even though they were expected. Investors also had a view that there would be higher losses; they did not know the type of assets held by bank. Uncertainty of the type of assets held by the bank and lack of information about the expected losses on these assets are some of the factors that led investors to discount the share prices far below their tangible book value. One of the reasons for revival of confidence in Banks in May of 2009 was the publication by Federal Reserve of detailed expected losses under stress scenario. This gave some comfort on the range of the losses that would be expected in certain scenarios and type of the assets held by the banks.

The current Incurred method front loads the income and back loads the losses. The new method will front load the losses and income will be back loaded. The new method has stated the asset should be stated at the Present value of the expected cash flows discounted by effective rate. Amongst the various proposed rules over the years, the current proposed standards FASB (Financial Instruments- Credit losses sub topic 825-15) tries to address the shortcomings in the previous versions of the rules.

If a bank is holding the same assets in securitized form instead of a loan, then the banks are required under current rules to mark down the securitized assets to the Fair value. However the losses on the same assets, but in different form are booked differently in the Bank's balance sheet. This expected loss rule attempts to bridge the gap that loans are treated differently from securitized assets.

Currently the financial institutions calculate Risk Weighted assets (RWA) to calculate the capital required under various regulatory regimes. Various investors and International regulatory bodies have highlighted the differences in calculation of RWA. Attempts are being made to standardize the methods to calculate the RWA. Banks also disclose other metrics like VAR and there are various methods to calculate the VAR. Investors recognizes these differences and are aware of inherent difficulties of models. They still value these disclosures and query the management on the calculation of these to better understand the financial strength of the banks. Proposed rules of booking of Expected losses instead of Incurred losses along with related disclosures will give far more color to the investors than the existing rules. Financial instruments are complex and different investors, managements will have a different view about the profitability of those. Investors can form their view, with additional disclosures.