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New rules for calculating general loan-loss provisions: IDW ERS BFA 7
Executive Education / 16 March 2020

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Dr. Walter Gruber
Lecturer at Frankfurt School
Dr. Walter Gruber is a managing partner of 1 PLUS i GmbH. He has authored numerous publications, particularly in the areas of banking supervision, market and credit risk modelling and derivative financial products. He is a lecturer in risk management at Frankfurt School.

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Making provisions for “foreseeable counterparty default risks that have not yet been individually specified” – general loan-loss provisions

On November 28, 2018, the Banking Expert Committee (BFA) of the Institute of Public Auditors in Germany (IDW) issued a “Draft Statement on Financial Reporting: Risk provisioning for foreseeable counterparty default risks that have not yet been individually specified in the annual and consolidated financial statements of institutions subject to commercial law (general loan-loss provisions – GLLP) (IDW ERS BFA 7)”. At the same time, the IDW requested proposals for amendments and additions, which were subsequently published on November 7, 2019, and include further observations by the BFA based on the feedback they received on the draft. IDW ERS BFA 7 is a further development of the IDW Banking Expert Committee’s “Statement on the creation of general loan-loss provisions for latent credit risk in the annual financial statements of banks (IDW St / BFA 1 / 1990)”.

According to the general principles of commercial law governing general loan-loss provisioning, the latter should be made by reference to each bank’s individual business model. The general valuation principles set out in Section 252 (1) no. 4 in conjunction with Section 340a (1) of the German Commercial Code (HGB) obliges banks to value their assets “prudently”; in particular, by taking all foreseeable risks and losses into account. In this context, risks and losses are deemed to be foreseeable if they “are identifiable as possible future losses on the basis of sound business judgement and if there are genuine reasons for expecting them to occur”. By their very nature, these risks and future losses are already foreseeable when a contract is first concluded, and should be taken into account when making general loan-loss provisions. It is important to emphasise that general loan-loss provisions should be made irrespective of whether and to what extent provisions have already been made for general banking risks (pursuant to Sections 340f and 340g HGB). The amount should be based on the loss of assets that would result from the failure to fulfil contractual capital and/or interest obligations in the originally agreed amount over the lifetime of the receivable (i.e. should be based on the lifetime expected loss or LtEL). If counterparty default risks have been specified for individual borrowers (e.g. as a result of loss events that have already occurred), specific loan-loss provisions (SLLP) should be made for these borrowers in accordance with Section 252 (1) no. 3 HGB.

Principles for calculating general loan-loss provisions

Because commercial law does not specify any particular method for calculating general loan-loss provisions, banks are free to select their own method, albeit in accordance with the following guidelines:

  • Based on the principle of “sound business judgement”, the method or process should allow for the appropriate and prudent estimation of expected losses over the remaining term of the contract. This means calculating not just the expected loss over one year, but the lifetime expected loss (LtLE).
  • The calculation should be based on credit defaults observed in the past. This means that a sufficiently long observation period should be applied to ensure that the quality of the forecast is adequate even when taking business cycles into account. The process should also take account of the latest information on and expectations of the current risk situation.
  • The choice of method should be consistent with the complexity and potential risk associated with the business model, and should be based on data, information and expectations available in the bank. The calculation of general loan-loss provisions may be portfolio-specific, using procedures of varying complexity as appropriate.
  • To comply with the principle of prudence prescribed by German commercial law, the calculation of general loan-loss provisions should take model risk into account (e.g. when determining probabilities of default (PDs), loss-given default (LGDs) and exposure amounts at default (EaDs)). If appropriate, a model buffer should also be recognised as an additional capital charge for general loan-loss provisions.
  • When calculating general loan-loss provisions, expected losses (LtEL) may be reduced by the net present value of any credit-rating premiums included in the customer agreement. In such cases, the credit-rating premiums should only reflect the credit risk anticipated at the time the transaction was concluded.
  • The lower limit for general loan-loss provisions (“GLLP floor”) should be based on the expected loss over one year, without taking credit-rating premiums into account. This lower limit may only be further reduced “in justified exceptional circumstances”.

Benefits of certification courses

The new rules for calculating general loan-loss provisions represent what amounts to a methodological quantum leap – especially for banks that have not yet applied IFRS 9 standards to their financial reporting – because risk provisions must now be calculated on the basis of statistical/actuarial mathematics. Frankfurt School students training to become certified credit risk managers are given the mathematical and regulatory grounding they need to emerge fully prepared for these new requirements.

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