Economic Loan Loss Provision and Expected Loss

The intention of a loan loss provision is the anticipation of the loan's expected losses by adjusting the book value of the loan. Furthermore, this loan loss provision has to be compared to the expected loss according to Basel II and, in the case of a difference, liable equity has to be adjusted. This however assumes that the loan loss provision and the expected loss are based on a similar economic rationale, which is only valid conditionally in current loan loss provisioning methods according to IFRS. Therefore, differences between loan loss provisions and expected losses should only result from different approaches regarding the parameter estimation within each model and not due to different assumptions regarding the outcome of the model. The provisioning and accounting model developed in this paper overcomes the before-mentioned shortcomings and is consistent with an economic rationale of expected losses. Additionally, this model is based on a close-to-market valuation of the loan that is in favor of the basic idea of IFRS. Suggestions for changes in current accounting and capital requirement rules are provided.