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 frameworks—incentives 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 denomination—balance 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