The Art & Science of Provisioning for Impaired Assets Dave Grace Managing Partner Dave Grace & Associates February 2013

Is this an Asset?

Who is Dave?  6 years central bank in USA  13 years World Council of Credit Unions (WOCCU)  18 months consultant IMF/WB  Worked in 60+ countries

Agenda Impairment of Assets in Financial Institutions Terminology Determining when to create provisions for loans and investments How to create provision and recognize collateral Writing off assets Recognition of Recoveries

IFRS 9 - Impairment of Financial Assets Exposure Draft Q Supplemental Document Q Re-Exposure Draft Was Expected in Q4 2012

IFRS 9 – Response to Provisioning process that didn’t work in Crisis IFRS 9 – Response to Provisioning process that didn’t work in Crisis FASB and IFRS have had different approaches resulting in complex proposals. Standard is taking a long time. Core Issue: Likelihood of a loss event in the next 12 months -- forward looking provisioning.

Terminology Impaired Asset = bad loan or investment. Non-performing loan = delinquency. Provisioning is an expense to the Income Statement. Allowance for loan/investment loss is a cumulative account on the balance sheet. Write off = Charge off.

Provisions & ALL 1. When is a loan delinquent? 2. What is the aging schedule? 3. Can collateral Values be counted? 4. How to determine collateral values?

When is a loan delinquent? Current Regs: 91 st day PEARLS: 31 st day

Aging Schedule Aging of NPLs 1-3 mo.4-6 mo.7-9 mo.10-12mo.13+ mo. Regs0%25%50%75%100% PEARLS35% 100%

Can Collateral off set the required provision expense? Yes, if: - It’s a loan secured by land, building or new car loan. - CU will realistically repossess collateral in a timely manner & courts allow it. - The CU can sell the collateral. - CU has recent valuations of collateral meeting the following criteria. If process too complex or CU does not have records to validate collateral values, then collateral CANNOT be used to off set the amount needed for provisions.

Valuing Criteria Collateral independently appraised within last 2 years & appraisal shows at least two comparable sales to justify the value. 2 years of data on showing actual forced sale prices for collateral types vs. appraised values. Determine haircut and apply this amount.

Example: Example: Mortgage is 8 months delinquent. Value of remaining loans is $220,000. Member has $500 is shavings & shares. Exposure to be provisioned is $110,000-$500 = $109,500 Recent appraisal (including comparable sales) assesses value at $240,000. Actual experience at this Financial Institution (FI) is that forced sales sell for 30% less than appraised value. Exposure =$109,500 Collateral value less 30% haircut =$168,000 (ie. $240,000*.70) Amount to provision= $109,500 - $168,000= -$58,500 =$0

Near Real Life Example A FI has a $465,000 loan for restaurant equipment that is 7 years past due. The restaurant has been vacant and vandalized for 7 years. Only collateral is a parcel that the FI does not have title to. ◦What should it do?

Writing off assets You first need to make provisions to create the allowance for loan/investment loss. Any loan or investment not performing for 12 months should be written off. ◦Example a FI that has not written off loans in 30 years. A FI that has never repossess as asset for a bad loan in 26 year history.

Recognition of Recoveries Once a loan is written off any proceeds from additional collection activities should come into the income statement as recoveries, not into the allowance for loan loss.

Thank you.