Considering Crises
In a bid to enhance financial stability, commercial banks will now have to adopt a revised Probability of Default (PD) model that takes into account “extraordinary crisis situations” like the International Monetary Fund (IMF) crisis or global financial downturns when provisioning their loan loss reserves. This new PD model must receive approval from financial regulators and is expected to lead to a more conservative approach in reserve calculations, resulting in higher reserve allocations by banks. Beginning with their financial reports for the second quarter of this year, banks will apply this new PD model.
According to financial industry sources on July 25, the Korean Bankers Association issued the updated guidelines for loan loss reserves to commercial banks. These guidelines were developed by a specialized task force consisting of financial regulators and bank professionals.
The revised guidelines include the provision that “banks may utilize a ‘representative PD’ in determining their reserve allocations.” Until now, banks have relied on their internally estimated “experience PD” to determine the appropriate reserve size. However, under the new guidelines, banks must also take representative PD into consideration.
Experience PD reflects the predicted default rate for the next year by comprehensively analyzing the trend of non-performing loans over a specific period. For instance, it forecasts the default rate for the next year based on the non-performing loan trends observed over the last decade. On the other hand, the representative PD is linked to the “regulatory purpose PD” utilized by banks when calculating the Basel Committee on Banking Supervision (BIS) ratios. Regulatory purpose PD is a conservative default rate calculated by considering extreme crisis scenarios such as the IMF crisis or global financial crises in the past. Banks generally find regulatory purpose PD to be 1.3 to 2 times higher than experience PD, leading to higher reserve provisions when applying representative PD.
An important aspect of the new guidelines is that the regulatory purpose PD necessitates approval from financial regulators. This signifies a more direct involvement of regulators in the process of determining reserve provisions compared to their previous practice of merely recommending that banks increase their reserves.