What is dynamic provisioning?
Dynamic provisioning is a macro-prudential tool to enhance bank soundness and to help mitigate part of the procy clicality of the banking system.
It is a way to ensure that banks aren’t hit by rising loss reserves at exactly the same time their lending powers are required in order to help stimulate an ailing economy
So the dynamic provisioning framework recognizes that credit risk is incurred during booms when loan portfolios are expanding, such that loan losses are already lurking on the balance sheets of banks, although they have not yet been allocated to a specific loan.
Birth of dynamic provisioning
Spain’s central bank put dynamic provisions into place in July 2000, to cope with a sharp increase in credit risk on Spanish banks’ statements of financial position following a period of significant credit growth.
Criticism of dynamic provisioning
Dynamic provisioning is inconsistent with IAS 39. Both do not compliment each other as dynamic provisioning is based on an ‘expected loss’ model whereas IAS39 contends an ‘incurred loss’ approach to loan impairment.
The recognition after identification of evidence, such as a counterparty failing to meet its contractual obligations, is much too late because the expenses in the income statement for impairments then accumulate in economic downturns when losses materialized. In good times, when lending is already at a high level, banks are not required to set aside buffers for expected losses, and thus overstate the economic value of the loan portfolio and understate losses in the income statement. In economic downturns high credit losses occur, but the lack of available provisions increases the losses reported in bank s’ income statement, which reduces capital and may force banks to recapitalize or reduce lending and sell assets. Hence, provisions set aside in good times could serve as a buffer against risk; one that alleviates the impact of those effects and reduces the likelihood of banks becoming insolvent.
The dynamic provisioning model contrary to the incurred loss model follows the main objective to improve the financial soundness of banks. Dynamic provisioning applies an anti cyclical approach, i.e. in “good times” a loan reserve is set-up so it will not face insolvency due to charge-offs and provisions in “bad times”
Congruence between dynamic provisioning and IFRS9
Dynamic provisioning is a tool to calculate the ‘expected loss’ on a loan at inception. But IASB categorically rejected ‘through-the-cycle’ approaches (and specifically dynamic provisioning). The board concluded that such approaches:
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