Disclosures of expected credit losses around the beginning of a crisis: Evidence from European banks during the COVID-19 pandemic

The International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) have recently adopted expected credit loss models for the loan loss provisioning of banks. The new regulations are a response to the 2008-09 financial crisis and the widespread view that loan loss provisions were “too little, too late” under the former incurred credit loss model. The expected credit loss model represents a more forward-looking approach and is designed to shift loss recognition to a much earlier stage of the economic cycle. We use a small sample of large European banks that provide sufficiently detailed disclosures of their provisioning choices under the new International Financial Reporting Standard (IFRS) 9 regulation prior to the COVID-19 crisis to examine whether banks had built up sufficient capital buffers at the onset of the crisis. Our evidence indicates that banks’ loan loss provisioning under the new expected credit loss model was lower in the period immediately before the crisis than it would have been under an incurred loss model (largely because of reversals). Therefore, the increase in loan loss recognition during the crisis was even larger, potentially amplifying procyclical effects and leading the European Central Bank to practice regulatory forbearance. The effect results from the exogenous nature of the pandemic, which banks did not consider in their internal loss estimates when determining expected credit losses. Increased reporting discretion in banks’ estimation procedure further augments the effect.