Banking is risky and lending money to unworthy borrowers is even riskier but banks indulge in such operations due to the higher spread (the difference between the rate charged by the bank and the cost incurred in raising the funds) and they look at it as a nice money-making opportunity. They get burnt in the process when the borrowers default on their obligations. To absorb such loss the banks need to keep aside certain capital.
Computing the capital requirement is quite a tricky and two-edged sword. If you keep excess amount than required then you are losing out on investing options thereby incurring opportunity cost in the form of foregone revenue and if you keep a lower amount then it might not be enough to absorb the loss in case of default. So how do the banks compute the requirement? Well for ages they used something called Incurred Loss Model.
IAS 39 related to Financial Instruments: Recognition and Measurement recognized an impairment of financial assets by stating the “incurred loss model”. The model is based on the principle that everyone is innocent unless proven guilty, drawing parallelism the model assumes that all loans will be repaid until evidence to the contrary (stated as a loss or trigger event) is identified.
This works well in most circumstances but fails miserably during economic turndowns. During such situations, the default rates increase, banks are required to keep aside additional money which in turn reduces their lending ability. This leads to scarcity of liquidity and the entire economy falls into a circular trap. This is exactly what transpired during the US Housing Crisis and to avoid such scenarios the Financial Accounting Standards Board (FASB) mandated the banks to adopt the “Expected Loss Model”.
The basic principle of this model is that all apples are not the same. All borrowers are not the same and some have a high probability of default compared to others. So what you do is built-in models including as many explanatory variables, use statistical techniques and make predictions. Once you know the potential loss you set aside the figure as soon as you disburse the loan. Provisioning based on expectations.
Would this have averted the 2008 Crisis?
Well, banks at that time were lending out to borrowers with no credit history and were not keeping aside money to account for the future loss. Had they done so, then they would have realized that they were keeping aside huge amounts as a cushion for bad loans which they could have used in a better way. Banks then would have scaled back and turned more prudent in their lending thereby reducing the inflationary condition. The ease of credit had created excessive liquidity which led to high demands and soaring real estate prices and when the bubble burst everything fell apart. Back then, had the banks reduced their lendings then there would not have been excess credit and excess demand thereby stabilizing the housing prices.
So What's the Point?
In India, we use a personalized version of the accounting standards which are known as Ind-AS. although IFRS 9 had made the use of the Expected Credit Loss Model mandatory, the Ind-AS 109 was in the transitory phase with the banks slowly moving away from the Incurred Loss Model to the Expected Credit Loss Model. The transition was supposed to be completed within FY 2021-23 but now it seems that the date will be pushed backs as banks are not keen on changing their approach. RBI can't force the banks to change their approach as the economic condition is demanding.
On one hand, it's risky to lend to borrowers with bad credit records and high risks without setting aside capital to absorb these losses, an action that can lead to bankruptcy and discontinuance of business as witnessed in the Crisis of 2008. So banks should keep aside the money and implement the Expected Credit Loss Model!!
But on the other hand economic conditions are not great, banks are lending to people with no jobs or businesses with no future. If they Implement the Expected Credit Loss Model then they will have to keep aside huge sums of money as a cushion against default. This will drastically decrease the corpus available for lending!! So fewer people and businesses will get loans. One of the major contributors to this crisis is the liquidity issue, people have wealth but it's not changing hands, there is no circulation of money. In such a scenario we should be pumping in more liquidity not curtailing it! So if banks adopt the Expected Credit Loss Model and reduce the loans then it will add to the crisis!!
So on one side lending freely without providing a cushion can bring the bank's existence into question and the collapse of banks will lead to another crisis whereas on the other side, not doing that will add directly to the economic crisis. We are standing on a knife's edge and have to tread carefully. Decisions at this time shape the future of a nation. We have to accept that winning might not be an option over here and we need to come up with an approach that will cut the losses. Minimize the casualties, that is the approach!!