No. 124: Limitations of Implementing an Expected Credit Loss Model

Abstract

The IFRS 9 loan impairment rules require banks to estimate their future credit losses using forward-looking information. We use supervisory loan-level data on German banks’ internal rating models to investigate how banks apply their reporting discretion and adjust their lending upon the announcement of the new rules. Our research design exploits a cutoff for the level of provisions at the investment grade threshold based on banks’ internal borrower rating. We find that banks required to adopt the new rules assign better internal ratings to the same borrowers compared to banks that do not apply IFRS 9 around this cutoff. This pattern is consistent with the strategic use of the increased reporting discretion inherent to rules requiring forward-looking loss estimation. At the same time, banks also reduce their lending exposure to precisely those borrowers at the highest risk of experiencing a rating downgrade below the cutoff. The lending change thus mitigates some of the negative effects of increased reporting opportunism on banks’ crisis resilience.