The COVID-19 pandemic has exposed the flaws in regulators' attempts to reduce procyclicality following the global financial crisis, the head of regulation at Spanish bank BBVA said Oct. 22 at the Financial Times Digital Summit.
Specifically, a new expected loss regime under the new IFRS 9 accounting standard has had unintended consequences, Santiago Fernández de Lis said.
"Financial regulation should aim at being at least neutral, and the problem is that very often [it] introduces additional procyclicality," Fernández de Lis said during a panel discussion.
The post-2008 regulatory reforms helped raise banks' capital and liquidity levels and the sector entered the coronavirus crisis in much better shape, he said. But some of the new requirements are making it hard for them amid the current downturn.
One of the reforms adopted — accounting based on expected losses — was intended to reduce procyclicality, but in practice is having the opposite effect, Fernández de Lis said.
If banks make provisions on expected losses, in theory they should not depend on the current state of the economy, therefore allowing them to spread the crisis-related burden along the cycle. But IFRS 9 standards have been designed such that when loans are migrated from performing to nonperforming, banks need to change the time horizon of provisions from a year to the lifetime of the loan — and therefore need to multiply the need for provisions.
As this move from performing to nonperforming happens during a downturn, the effect on provisions is actually the opposite of what was intended, Fernández de Lis said, adding that this has been witnessed during the coronavirus crisis.
European banks' loan loss provisions have spiked since the onset of the pandemic and there is still a divergence in expected loss models as different institutions are taking different views on the length and depth of the COVID-19 crisis.
Early on in the COVID-19 crisis, European regulators allowed banks to delay some of the loan migration under IFRS 9, thereby easing the procyclical effect. But, Fernández de Lis said, there should be some review of the accounting rules in the future. There are other areas that potentially would require a change to reduce procyclicality in financial regulation — for example, capital buffers, he said.
The countercyclical buffer was another tool introduced after the previous crisis to address procyclicality.
"You activate it in good times, and you reduce or eliminate it in bad times," Fernández de Lis said. The problem was that many countries, including Spain, did not adopt countercyclical buffers at all. Furthermore, having a countercyclical buffer in a neutral cyclical situation is not a solution because this would imply an increase in the capital levels.
"And at this stage, we should also ask ourselves [about] the adequacy of the capital levels," Fernández de Lis said.
Regulators including the Bank of England are considering changing the balance between the countercyclical buffer and other structural buffers such as the systemic buffer and the capital conservation buffer, Fernández de Lis said. The idea is to increase the share of the countercyclical versus other buffers, and it is a good one, he said.
Bank of England Deputy Governor Jon Cunliffe said the rules on bank risk buffers may need to change to ease lending after the pandemic, Reuters reported Oct. 15.
In general, the whole capital structure and what goes into it under current regulations should be reviewed in order to find ways to simplify it, Fernández de Lis said. Apart from the stacking of capital buffers, banks are required to also hold total-loss absorbing liabilities to be used in case of failure, he pointed out.
Therefore, simplification and making the financial regulation less procyclical should be addressed by the Basel Committee on Banking Supervision and the Financial Stability Board, he said.