Accounting for credit risk: are the rules setting the right incentives?

Abstract

Banks again and again surprise the public with unexpected high provisions for loan losses sometimes threatening the financial viability of individual companies or even the stability of national financial systems. The paper analyses whether the patterns of loan loss provisions are, in part, attributable to the rules of accounting for credit risk. It compares the national German rules with the related IFRS rules and identifies inconsistencies across different types of transactions in both regimes. The analysis of the accounting rules is combined with an analysis of incentives for under-provisioning and/or over-provisioning, emanating from the capital markets and from banking supervisory authorities. The conclusion is that, in particular, the IFRS accounting rules should be changed to require a more comprehensive accounting for expected losses that can be measured reliably, using information readily available in the markets.

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