Banks are not taking enough risk if no loans ever go bad – after all banks are in the business of providing risk capital at an appropriate price. But given a certain proportion of loans will go bad, how should banks provide for them in their accounts without knowing exactly which ones will tip over?
"Businesses which are losing money because the economy has been brought to a halt but can be expected to survive on the other side are being propped up.”
In this time of global pandemic, that is truly a multi-billion dollar question.
Back in the 1990s, after Australia’s last recession, the banks began to move towards “dynamic” or “expected loss” provisioning. Based on history and data modelling, they would set aside – provide – a certain percentage of the loan book to cover future bad loans even though those loans hadn’t yet failed.
That made sense: it meant reserves were stashed away for when they were needed. But this regime fell out of favour because of the view it could be used to sandbag future results. And, some argued, why should today’s shareholders pay for tomorrow’s – estimated - losses?
However, not providing for unknown but inevitable bad loans in advance meant bank profits were inflated in good times and plunged, pro-cyclically in bad.
The current accounting standards require two kinds of provisions to recognise this tension: individual provisions – for known bad loans – and general provisions– to account for the prevailing environment and the potential for bad loans in the future.
COVID-19 however is not surprisingly a major challenge for the system.
Loans which would be expected to fail are being held aloft by government support of business, prudential dispensation by regulators, deferrals by lenders and legal allowances for company directors.
From one perspective, this is sandbagging on an economy-wide scale. Surely, at some point in this dire recession a sizeable proportion of those loans will go bad?
Hopefully not. The intention of these measures is to support borrowers through what is currently a customer rather than insolvency crisis. Businesses which are losing money because the economy has been brought to a halt but can be expected to survive on the other side, when customers are allowed out, are being propped up.
Of course, not all will. This is a catastrophic recession and could yet – given the second and third waves of contagion around the world – become a depression.
Before the virus
The Reserve Bank of Australia’s (RBA) biannual Financial Stability Review warned business failures will rise – although they haven’t yet. Just as “excess mortality” data give us an insight into how many lives the coronavirus is ending prematurely, insolvency data show business life support is keeping an excess number of companies alive. Insolvencies recorded by the Australian Securities and Investments Commission (ASIC) are running around 75 per cent lower than for the comparable period last year – before the virus.
That may be changing: data show defaults rising 23 per cent in September, having been stable since May. Companies entering voluntary administration rose by 11 per cent over the same month, according to data from CreditorWatch.
“Business failures will increase, although there is a high degree of uncertainty about the magnitude and timing,” the RBA warned. “It will depend on the strength of the economic recovery, which will be influenced by the duration and severity of future COVID-19 related disruptions, and the timing and extent of the unwinding of the various support measures.
“Bankruptcies and insolvencies are currently very low because of the income support, loan repayment deferrals and temporary insolvency relief.”