1. This document, issued by the Basle Committee on Banking Supervision ¹, provides guidance on recognition and measurement of loans, establishment of loan loss allowances, credit risk disclosure and related matters. It sets out banking supervisors' views on sound loan accounting and disclosure practices for banks ². The document also serves as a basic framework for supervisory evaluation of banks' policies and practices in these areas.

   (a) Objectives

2. Three objectives underlie the issuance of this document on loan accounting, credit risk disclosure and related matters:
   1. To provide guidance on sound practices to banks, supervisory agencies and accounting standard-setters.
   2. To promote enhanced policies and practices, which are consistent with sound risk management practices, of banks in both G-10 and non-G-10 countries.
   3. To promote convergence of policies and practices across banks and countries.

3. The guidance in this document is founded on the precept that accounting policies and practices should ensure that loan assets, capital and income are fairly and prudently stated. In many respects, the document sets out principles that are already widely accepted in many countries. Nevertheless, the Basle Committee believes that this document can play a useful role by addressing the need for improvements in accounting and disclosure standards for banks' lending activities.

4. This guidance emphasises that three of supervisors' primary concerns should be a) the adequacy of an institution's process for determining allowances, b) the adequacy of the total allowance and c) the timely recognition of identified losses through either specific allowances or charge-offs.

5. The publication of this paper is a component of the Committee's long-standing work to promote effective banking supervision and safe and sound banking systems. In the Basle Core Principles ³, the Committee defines minimum requirements for an effective banking supervisory system and discusses arrangements to promote stability in financial markets. This document elaborates on certain of the Core Principles, which require banking supervisors to be satisfied that:
   • banks establish and adhere to adequate policies, practices and procedures for evaluating the quality of assets and the adequacy of loan loss provisions and loan loss reserves (Principle 8) ⁴;
   • each bank maintains adequate records drawn up in accordance with consistent accounting policies and practices that enable supervisors to obtain a true and fair view of the financial condition of the bank and the profitability of its business (Principle 21, 1^st clause);
   • each bank publishes on a regular basis financial statements that fairly reflect its condition (Principle 21, 2^nd clause).

   (b) Scope

6. Since this paper is an elaboration of certain of the Basle Core Principles, it applies to all banking organisations. As discussed later, the methods by which the guidance is implemented should reflect the scope and complexity of individual banks' operations.

7. The focus of this paper is primarily on accounting and disclosure practices relating to the credit risk in loans held in the banking book. Credit risk is of course present in activities other than lending. While valuation and the establishment of allowances relating to credit risk in other banking activities (e.g., trading and derivatives activities) are generally outside the scope of this paper, the Basle Committee believes that banking organisations should ensure that the credit risk in these areas is prudently measured, managed and disclosed in their financial statements ⁵. Many of the principles in this paper should be helpful to institutions and their supervisors in addressing those accounting and disclosure issues.

8. In many countries, accounting policies are to a greater or lesser extent influenced by fiscal considerations. For example, most countries that are members of the Basle Committee grant tax deductibility to specific allowances/charge-offs in the year they occur. However, convergence in tax treatments lies outside the scope of this paper.

   (c) Background

9. Banking supervisors have a legitimate interest in sound and prudent accounting principles and practices, and in appropriate disclosures by banking organisations. Generally, banking supervisors provide supervisory guidance that includes supervisory reporting standards and capital adequacy requirements. In some jurisdictions, banking supervisors have no authority to decide on accounting principles and practices. However, in several countries, banking supervisors do provide accounting standards, accounting guidance or elaborate on generally accepted accounting principles for banks' public financial statements and prudential reports used by supervisors. Accounting treatments generally, and loan accounting treatments specifically, can significantly affect the accuracy of financial and supervisory reporting and related capital calculations. Moreover, sound accounting and disclosure practices are essential to ensure the transparency needed to facilitate the effective supervision and market discipline of financial institutions.

10. There is considerable interest in achieving further harmonisation and in strengthening transparency of loan valuation, the establishment of loan loss allowances, and credit risk exposures. In addition to the Basle Committee, the G-7 Finance Ministers, G-10 central bank Governors and international agencies such as the International Monetary Fund (IMF) and the World Bank have called for progress in this area.

11. All supervisors are encouraged to review their current rules or recommendations against the guidance provided in this paper and amend their rules, as appropriate, in ways that are best suited to their national systems ⁶. This guidance may also be of assistance to accounting standard-setters as they work on setting more uniform rules. Also, supervisors may have reasons to recommend enhancements in national accounting or disclosure rules and to consider introducing special regulatory guidance, e.g. for capital adequacy and supervisory reporting purposes, in countries where national rules do not lead to sufficient levels of loan loss allowances.

12. Accounting: Adequate accounting policies and practices for a bank's lending activities are an essential part of a sound and effective credit risk management process in a bank. Experience indicates that the most common cause of bank failures, by far, is poor credit quality and credit risk management. Failure to identify and recognise deterioration in credit quality in a timely manner can aggravate and prolong the problem. Unless deterioration is identified and losses recognised by the establishment of adequate allowances or charge-offs in a timely manner, a bank may well persist in highly risky lending strategies or practices and thus accumulate significant loan losses, possibly resulting in failure. From a safety and soundness perspective, therefore, it is important to bank supervisors that the accounting principles used by banks reflect prudent and realistic measurements of assets, liabilities, equity, derivative contracts, off-balance sheet commitments, and related profits and losses. Capital adequacy requirements provide some cushion against loan losses, but if underlying accounting policies are weak, the resulting capital situation may well be overstated ⁷. Thus, inadequate accounting treatments undermine the usefulness of capital requirements and hamper proper assessments and sound management and control of a bank's credit risk exposure. Moreover, significant differences in accounting treatments may be a source of competitive distortions.

13. Disclosure: Sound accounting standards also are necessary to achieve satisfactory transparency, i.e., public disclosure of reliable information that enables market participants and other users of that information to make an accurate assessment of a bank's financial condition and performance, its business activities and the risks related to those activities ⁸. Disclosure of reliable information based on sound accounting principles and internal control systems facilitates market discipline and strengthens confidence in the banking system. In contrast, insufficient disclosure increases the chance that misleading information could cause market instability. By facilitating market discipline, accounting and disclosure help reinforce supervisory efforts to encourage banks and other market participants to maintain sound risk management practices and internal controls. Experience indicates that the degree of transparency with respect to the credit risk of banks' lending activities in G-10 and non-G-10 countries can be improved.

14. It is recognised that discussions are underway among national and international accounting standard-setters on ways in which accounting for financial instruments, including loans, can be harmonised and improved. For instance, the International Accounting Standards Committee (IASC) and several national accounting standard-setters are undertaking a joint long-term project addressing recognition and measurement issues with respect to financial assets and financial liabilities, including consideration of fair value accounting ⁹.

15. The Basle Committee will continue to keep accounting and disclosure matters under review to the extent that they affect supervisors' mandate to promote safety and soundness of banks and the stability of financial systems. It intends to work with accounting standard-setters to promote the enhancement and harmonisation of accounting standards as they relate to banks. Moreover, the Committee is currently developing a separate paper on credit risk management, a complex topic in which accounting policies play an important part.

    (d) Outline of paper

16. Following a brief discussion of some fundamental considerations pertaining to accounting and credit risk management in section 2, the paper in section 3 elaborates on sound practices for loan valuation, establishment of loan loss allowances and other loan accounting issues. Sound disclosure practices regarding lending activities and credit risk are discussed in section 4 of this paper. Emerging issues, such as fair value accounting and new provisioning approaches, are discussed in section 5. The role of supervisors in assessing a bank's loan accounting policies and practices is set out in section 6.

    (e) Terminology

17. In international discussions of loan accounting and disclosure, misunderstandings can arise due to differences in terminology across countries. In this paper, a consistent terminology is applied:
    • A 'loan' is a financial asset resulting from the delivery of cash or other assets by a lender to a borrower in return for a promise to repay on a specified date or dates, or on demand, usually with interest. Loans comprise:
      1. consumer instalments, overdrafts and credit card loans;
      2. residential mortgages;
      3. non-personal loans, such as commercial mortgages, project finance, and loans to businesses, financial institutions, governments and their agencies;
      4. direct financing leases; and
      5. other financing arrangements that are, in substance, loans.

    • The 'recorded investment' in a loan or group of loans is the face or principal amount, taking into account payments applied to reduce principal, and adjusted to reflect accrued but uncollected interest, charge-offs, unamortised premium or discount (i.e., a difference between acquisition cost and principal) and unamortised loan fees and costs.

    • The 'carrying amount' of a loan or a group of loans is the net amount reported for the loan or group of loans on the balance sheet, i.e., the recorded investment less any specific and general allowances. ¹⁰

    • Loan 'impairment' represents deterioration in the credit quality of one or more loans such that it is probable that the bank will be unable to collect, or there is no longer reasonable assurance that the bank will collect, all amounts due according to the contractual terms of the loan agreement(s). ¹¹

    • An 'allowance' ¹² for loan impairment is the amount that reduces the recorded investment in a loan or a group of loans to the carrying amount on the balance sheet.
      • A 'specific allowance' is an allowance that is established against a loss that is identified in an individual loan. As a practical expedient, specific allowances against losses in pools of collectively assessed small-balance loans with common characteristics (e.g., credit card balances) can be established on a formula basis. ¹³
      • A 'general allowance' is an allowance that is established for latent losses that are known to exist, but cannot yet be ascribed to individual loans. ¹⁴

    • A 'charge-off' (or write-off) is made when all or part of a loan is deemed uncollectible or there is otherwise no realistic prospect of recovery. A charge-off reduces the recorded investment in the loan and, if allowances previously have been established, the amount of allowances. ¹⁵

Footnotes:

1. The Basle Committee on Banking Supervision is a committee of banking supervisory authorities which was established by the central bank Governors of the Group of Ten countries in 1975. It consists of senior representatives of bank supervisory authorities and central banks from Belgium, United Kingdom and the United States. It usually meets at the Bank for International Settlements in Basle, where its permanent Secretariat is located.

2. Other financial institutions with significant lending activities and their supervisors may also find the guidance in the paper useful.

3. The Core Principles for Effective Banking Supervision were issued by the Basle Committee in September 1997 after consultation with banking supervisors worldwide.

4. As discussed in the section on terminology, this paper uses the term "allowance" instead of "reserve" since many accountants for conceptual reasons would avoid the latter term in the context of loan impairment.

5. The Basle Committee, jointly with the IOSCO Technical Committee, has issued disclosure guidance in the annual survey reports on trading and derivatives disclosure of banks and securities firms; the most recent report was issued in November 1997. Also, the Euro-currency Standing Committee's discussion paper on Public Disclosure of Market and Credit Risks by Financial Intermediaries (September 1994) contains disclosure recommendations for financial institutions' trading and derivatives activities.

6. Some supervisors may wish to complement the sound practices set out in this paper by providing more detailed guidance.

7. The Basle Capital Accord defines minimum capital requirements for banks on the basis of a risk-weighted approach to credit risk and market risk. In principle, specific allowances reduce risk-weighted amounts, while both specific and general loan loss allowances reduce tier 1 capital since these allowances are created through a charge to earnings which reduces equity capital. Under the Capital Accord, general loan loss allowances are included in tier 2 capital under certain conditions.

8. The Basle Committee has issued general recommendations about disclosures by banks in the paper Enhancing Bank Transparency, issued in September 1998.

9. The IASC issued the discussion paper Accounting for Financial Assets and Financial Liabilities in March 1997. An Exposure Draft of an interim international accounting standard on recognition and measurement of financial assets and financial liabilities (E62) was issued in June 1998.

10. In most countries, loans are reported net of allowances on the asset side of the balance sheet. However, in some countries, the asset side shows the recorded investment and loan loss allowances are reported on the liabilities side.

11. An insignificant delay or insignificant shortfall in amounts of payments does not necessarily constitute impairment, if, during such a period of delay, the lender can reasonably expect to collect all amounts due.

12. Allowances are sometimes referred to as provisions or valuation reserves. It should be noted that some accountants consider the use of the terms "provision" and "reserve" inappropriate when referring to accumulated value adjustments of loan assets: The IASC defines a provision as a type of liability, while a reserve is defined as a part of equity capital (IASC Framework for the Preparation and Presentation of Financial Statements).

13. Allowances established on a group basis against losses in pools of collectively assessed small-balance loans are considered as specific allowances only to the extent they substitute for allowances established against losses identified on a loan-by-loan basis.

14. In some countries, the process used to estimate the amount of latent losses in the loan portfolio considers the collectibility of some loans (generally larger-balance loans) individually and other loans (generally smaller-balance loans) on a pool basis.

15. The timing of charge-offs differs considerably between countries for legal, fiscal and other reasons. In some countries, a charge-off is taken against an individual loan rather than establishing a specific allowance against that loan. Nevertheless, banks should keep memorandum records of charged-off loans for the amounts still formally owed by debtors.