The impact of new accounting rules for bad loans?
By Jon Fernquest[Introduction|Vocabulary|Article]
[Reading Questions|Answers]
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The post-coup government has been taking every opportunity to make government operations in the post-Thaksin era more transparent and compliant with international standards. In the long-run this should lead to a healthier economy.
Today's article discusses the government's efforts to write off bad loans and realise the losses on bad loans early, rather than have them drag the whole economy down over long periods of time as they did in Japan during the 1990s.
In the short-run, bank profitability may suffer a bit, but in the long-run banks will be better placed to finance a growing economy.
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The writings of the economist Paul Krugman are the easiest way to get an intuition of why bad loans are bad for an economy. Read Paul Krugman on the logic of writing off bad loans in the Japanese economy [Source: Paul Krugman's papers on Japan, also see the Unofficial Paul Krugman Archive, note that a lot of Paul Krugman's essays relevant to Thailand are available in Thai translation at your local bookstore].
For more background reading, check out this IMF background paper on the Japanese banking crisis of the 1990s and Wikipedia on the American Savings and Loan Crisis of the 1980s. The American crisis didn't last long because losses on loans were taken early, whereas the Japanese crisis dragged on for years from a failure to realise losses on bad loans from the financial bubble that burst in Japan at the beginning of the decade.
Here's an interesting observation about the limitations of international accounting standards made by the the Secretary-General of the Securities and Exchange Commission back in 2004:
32. There can be no one language if it aims for too much perfection. This is also true of international accounting convergence. There may be local conditions that make it impractical, or even wrong, to adopt international standards in every little aspect. There may be times that international standards should not apply.33. Take the example of IAS 39 regarding debt restructuring. The standard requires for valuation of the restructured cash flows to be discounted by the original contract interest rate.
"34. However, in the case of Thailand, the financial landscape before and after the Asian crisis in 1997 simply could not be compared. There was a very big paradigm shift.
35. Before the crisis, typical lending rates were in the high teens, 16 per cent per year would not be abnormal, for example. Plus all contracts also had clauses that set penalty rates in case of delayed payments at the maximum, often 20 – 24 per cent per year. Those very high rates were set as deterrents, to scare debtors against default.
36. Unfortunately, during the crisis, almost half of all bank loans became non-performing. The penalty clauses had kicked in. Of course, no debtor could afford to pay those exceptionally high rates. They all had to be restructured to the rates prevailing after the crisis, mostly less than 10 per cent per year. Would it make sense to discount the restructured loans at the 20 – 24 per cent rate? Or even the 15 – 16 per cent normal rate pre crisis? I think not. The financial paradigm has shifted so much that it does not make sense to follow IAS 39.
37. What can we do under such a circumstance? In Thailand, we issued our local standard that required restructured loans to be discounted at the prevailing market rate. We ignored the original contract rate. But by doing so, we have to live with the label that Thailand does not comply with international convergence." (Source)
Kasikorn Research has had two recent, rather technical, notes on IASB39:
1. The affect of IASB39 on third quarter bank results (3 November 2006)
2. On IASB39 (5 October 2006)
Reading Questions
Here are some questions to guide your reading (See answers at end):1. What effect will the implementation of accounting standard IAS39 on the non-performing loans of Thai banks likely have on their earnings, both in the short and long run?
2. What will the implementation of accounting standard IAS39 require banks to do? (In general and also provide specific details)
3. Will all banks need to make large NPL provisions? Why or why not?
4. How do the affected banks rank in the NPL provisions they need to make?
5. How does IAS39 require banks to value loans differently than they currently do? What effect will this have? (Simplify and summarise what is said in the article.)
7. What percentage decreases in projected bank earnings due to NPL provisioning are analysts forecasting for the next few years? (Note: Calculation and then generalisation from the data required here)
Bangkok Post Article: November 17, 2006
New accounting rules for bad loans take shine off outlook
UMESH PANDEYPreparations for new accounting standards that must be met by 2008, coupled with a weaker economic growth outlook in the year ahead, have prompted brokers to advise investors that now is the time to take profit in Thailand's banking sector.
"There are various factors that have made us put an 'underweight' rating on the sector, including the implementation of the new accounting standards,'' said a banking analyst at a foreign brokerage.
Bank of Thailand governor Tarisa Watanagase said on Thursday that commercial banks would be required to set higher provisions against loan losses, beginning next month, to comply with new accounting standards.
The International Accounting Standard 39 (IAS39) will likely cause Thai commercial banks to raise their provisions three times to meet the requirements. The first round of increases, for the loans more than 12 months in default, will be in December, followed by another round, for defaults of six months, in June 2007, and the last one, for defaults of more than three months, in December next year, she said.
Dr Tarisa acknowledged that while the new standards may hurt earnings, they would benefit banks in the long run. It was a statement that could spook any investor looking to make a quick buck.
But analysts point out that in reality, only a few banks need additional provisions right now.
"In our estimates it is only TMB Bank Plc, Bank of Ayudhya Plc, Krung Thai Bank Plc and Siam Commercial Bank Plc that require additional provisions, and among the worst ones are TMB and KTB,'' said another foreign analyst.
According to his estimates TMB requires 13 billion baht in additional provisions, BAY around six billion, KTB 11 billion and SCB one billion baht. BAY's problems can be solved by the capital injection from GE Capital, while one billion baht for SCB is not a problem.
Under IAS39, banks will be required to value NPLs based on their current economic value, rather than their accounting value. This effectively means banks will have to discount back when they expect to receive actual cash from the liquidation of collateral backing an NPL.
"This will effectively raise the required NPL coverage level for the banks from 39% to 57%, an increase of 121 billion baht (53%),'' James Moss of CLSA Securities wrote in a recent report. "The most affected will be BAY, KTB, TMB and Kiatnakin Bank; these four will require additional provisions of 27 billion baht.''
Other banks, analysts say, are unlikely to see any material impact.
"The key reasons for the underweight ratings on the sector are: 1) the likelihood that the economy will show marginal growth as the US market cools after a sharp decline in housing prices, while China's economy doesn't grow at the same level; 2) the current political situation leads to slower investments and basically writing off 2007 for accelerated growth targets; 3) the increase in funding costs as depositors shift funds to higher-yielding rates in fixed deposits,'' said a broker.
Despite the grim picture, most analysts say capital increases for meeting the provisions were highly unlikely as most banks are relatively profitable.
"We view that neither KTB, TMB nor BAY will be adversely affected by the one-time provisioning of NPLs in 2007,'' said Suwat Bumrungchatudom, sector analyst at Bualuang Securities.He says the earnings for these banks would likely fall sharply. Bualuang puts TMB's earnings at 5.4 billion baht for 2006 and 652 million in 2007, against 6.8 billion and 6.4 billion baht forecast earlier. His forecast for BAY was cut as he expects the bank to set loan loss provisions of 750 million baht in Q4 this year and seven billion baht in 2007. `"Our profit projection would then fall from 10 billion baht in 2007 and 14 billion baht in 2008 to 5.3 billion baht and 9.2 billion baht, respectively after joining with GE,'' he says.
But not all analysts are negative on the outlook of the sector, Alastair Macdonald of Macquaire Securities (Thailand) says his house view is positive in line with the regional call for the sector.
"We remain overweight on the sector. For investors concerned about IAS39, the obvious strategy is to avoid the banks with lower provisioning coverage. Among our Outperform-rated stocks in the sector with robust provisioning cover and attractive upside to target, we would highlight Kasikornbank (outperform with a target price of 80 baht) among the big caps and Thanachart Capital Plc (outperform with a target of 18 baht) among the smaller banks,'' he said in a recent report.
Vocabulary (in discussion above)
in default - failure to pay back a loan on time, to make loan payments on time
a non-performing loan (NPL) - loans that are in default or close to being in default (See Wikipedia)
bad loans - non-performing loans
take the shine off - make less attractive (as an investment)
coupled with - combined with
x prompted y to z - x caused y to z
implementation - how to actually do the things in a plan
accounting standards - international regulations on what accounting information should be made public by corporations (See Wikipedia on international accounting standards)
provisions, provisions against loan losses - putting money aside to pay for and solve future problems, an uncertain liability, uncertain when the liability will arise and how much it will be for (this can include costs for corporate reorganisation, legal cases, non-performing loans in a bank; See Wikipedia)
comply with - follow laws or regulations, do what the law says you have to do
International Accounting Standard 39 (IAS39) - the international financial reporting standards that defines the valuation and reporting of financial instruments such as derivatives, loans, and employee option schemes(See Wikipedia)
make a quick buck - make money quickly
a capital injection - investing and putting money into an already running project
economic value - the value of an asset if it is liquidated and sold on the market (See Wikipedia on fair value)
accounting value - the value of the asset on the balance sheet, which may not be its real market value
collateral backing a loan - property pledged to assure repayment of debt, if the borrower fails to pay the loan back (defaults) then the lender has the legal right to sell the assets to pay off the loan.
in default - failure to pay back a loan on time, to make loan payments on time
NPL coverage level - the extent to which bad loan assets on the balance sheet have their true value, kind of like insurance "coverage" for the likely loss when the bad loan is liquidated in the future
US market cools - GDP growth rate declines (from decreased wealth from home ownership, Keynesian wealth effect)
a write off, writing off x - accepting that you've lost money on x, or that x is worthless or worth a lot less than you thought (in accouting the word means roughly the same, but also has an exact technical meaning, see Wikipedia on accounting write offs)
depositors - people keeping their money in the bank
fixed deposits - bank deposit that must be kept at the bank for a fixed period of time (interest rate is higher than for a deposit that can be withdrawn at any time)
grim - unpleasant, depressing, and difficult to accept (like death)
relatively profitable - profitable when compared with other similar businesses
x adversely affected by y - y has had a negative effect on x
overweight on the sector - owns too much stock in the companies in this industry or sector (like someone who has too much weight, who is overweight)
provisioning coverage - provisions (accounting provisions are like insurance "coverage" against bad events whose time and cost are uncertain)
robust - strong
Answer Key:
1. What effect will the implementation of accounting standard IAS39 on the non-performing loans of Thai banks likely have on their earnings, both in the short and long run?
They may hurt earnings in the short-run, but they would definitely benefit banks in the long-run.
("Dr Tarisa acknowledged that while the new standards may hurt earnings, they would benefit banks in the long run. It was a statement that could spook any investor looking to make a quick buck.")
2. What will the implementation of accounting standard IAS39 require banks to do? (In general and also provide specific details)
In general, they will be required to "set higher provisions against loan losses, beginning next month."
Specifically, over the next year they will be required to "raise their provisions" three times, starting with the worst defaults (12 months) and ending with the least severe (3 months).
3. Will all banks need to make large provisions? Why or why not?
No, only a few "need additional provisions right now," and only a few of these need to make large provisions.
4. How do the affected banks rank in the provisions they need to make?
1. Thai Military Bank Plc - 13 billion baht
2. Krung Thai Bank Plc - 11 billion baht
3. Bank of Ayudhya Plc - 6 billion
4. Siam Commercial Bank Plc - 1 billion baht
5. How does IAS39 require banks to value loans differently than they currently do? What effect will this have? (Simplify and summarise what is said in the article.)
It requires them to use market value of loans in their balance sheets instead of accounting value. This will make the loans worth less and decrease the value of the bank.
6. What three factors are likely to have a negative effect on bank profit in the near future?
a. Slower growth as growth in the United States slows due to a decrease in housing prices (a Keynesian wealth effect) and as a result slower growth in China from decreased exports.
b. The "current political situation" in Thailand leading to "slower investment."
c. The necessity of banks paying higher rate of returns to depositors, as depositors "shift funds to higher-yielding rates in fixed deposits."
7. What percentage decreases in projected bank earnings due to bad loan provisioning are analysts forecasting for the next few years? (Note: Calculation and then generalisation from the data required here)
a. Thai Military Bank:
2006: -21%, 2007: -65%
b. Bank of Ayudhya:
2007: -47% 2008: -34%
