1. Accounting for Credit Default Risk in FISIM Brent Moulton Advisory Expert Group on National Accounts 13–15 April 2016

2. Overview What is credit default risk? How does it affect measured FISIM? Should it be included in FISIM? Proposal to remove credit default margin from FISIM 2

3. What is credit default risk? Paper refers to “charge-off rates” – Loan write-offs per period divided by loan balances Credit default risk – Risk that a loan won’t be repaid – May be measured by expected (normal) charge-off rate (“default margin”) Credit default risk varies across – Type of loan (credit card versus mortgage) – Time (before and after financial crisis) 3

4. How does credit default risk affect FISIM? Financial institutions charge higher interest rates to borrowers with higher credit default risk Credit default risk is included in borrower FISIM r loan = r reference + s r loan = interest rate on loans, r reference = reference rate, s = FISIM During periods of higher risk, lenders charge higher interest rates, causing borrower FISIM to grow – In United States (under old SNA 1993 treatment) commercial bank borrower FISIM at current prices increased 45% from 2007 to 2011. – Thus, even though gross lending was flat, measured nominal bank output was increasing 4

5. FISIM is a source of funds (instead of explicit fees) allowing financial intermediaries to purchase labor, capital, and intermediate consumption to produce services But the credit default margin is not available to pay for labor, capital, or intermediate consumption – Analogous to exclusion of adjusted claims from measured services of non-life insurance r loan – d = r reference + s d = default margin Should credit default risk be included in FISIM? 5

6. Previous Task Force and AEG recommendations In 2012 issues paper, majority of FISIM task force concluded that credit default risk should be excluded from FISIM, but recommended waiting for Eurostat tests. At 2012 AEG meeting, majority of AEG supported excluding credit default risk in principle, but recognized that it may be difficult to exclude it in practice. In 2013 final report, FISIM task force recommended on practical grounds that credit default risk remain part of FISIM, but recommended further research. At 2013 meeting, AEG could not agree on the conceptual merits of either excluding or including credit default risk and recommended that research continue. 6

7. Proposal to remove credit default margin Charge-off rate generally not an appropriate measure of credit default margin – Volatile – Charge-off rates refer to past loans that may have been non-performing for a while – Conceptually, prefer ex ante measure of expected default rate, relevant to interest rates currently being negotiated Alternative treatment – analogous to SNA 2008 treatment of adjusted claims in non-life insurance: d Q = d Q – 1 + 0.075 (c Q – d Q – 1 ) Q = quarter, Q – 1 = previous quarter, c Q = charge-off rate Parameter of 0.075 is based on average loan maturity for U.S. banks of about 3 years 7

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9. Effects of alternative treatment on U.S. national accounts BEA implemented this alternative treatment as part of its 2013 comprehensive revision For 2008, reduced overall commercial bank FISIM about 17% Because borrower services mostly assigned to intermediate consumption, effect on GDP was smaller – Revised down less than 0.1% Previously published increase in borrower FISIM (in current prices) of 45% from 2007 to 2011 was revised down to about 1%. 9

10. Proposal doesn’t deal with other issues This proposal is distinct from several other FISIM issues that have been discussed: There’s an argument that interest on non-performing loans shouldn’t be included in calculation of FISIM borrower services – Our proposal here, however, refers to principal, not interest Wang and coauthors (Basu, Fernald, Inklaar) have proposed also removing risk premium from FISIM – Default margin refers to expected loss (1 st moment) – Risk premium refers to premium required for risk averse investors to hold higher variance debt (2 nd moment) – Risk premium includes, and generally larger than default margin Proposal doesn’t require changes to SNA treatment of loan write-offs in “other changes in assets” account 10

11. Questions for discussion Should there be a “next step” in continuing research on this proposal? If so, what should the next steps be? 11