Structure of specific provisions

The development of accounting systems has given rise to asset valuation principles as a basic mechanism for anticipating the loss of asset values. These principles may be based on market information on asset prices (e.g., in the case of trading account assets, the price of securities held for trading), or on arbitrary solutions (e.g., in the case of tangible fixed assets). Similar principles cannot be applied to outstanding loans because of their different nature (trading is absent or limited, and they are not subject to wear and tear). Nonetheless, there is an undoubted need to evaluate asset quality (for both balance sheet reporting and prudential purposes). A claim that is highly likely to be repaid (e.g., on the Treasury) has a different value from one that is long past due (e.g., on an undertaking that is going bankrupt). The necessity of taking these factors into account is crucial at banks, where loan outstandings constitute a significant item on the balance sheet.

The system of asset classification and specific provisioning represents the equivalent of asset valuation principles. One expression of this approach is the inclusion of the requirement to establish specific provisions in the Accounting Act (as of 2002), with statutory authorisation to determine the detailed procedures involved being vested in the Minister of Finance (this was previously the responsibility of the Commission for Banking Supervision, which reflected emphasis on the prudential character of specific provisions).

Scope of application

Classification and provisioning procedures apply to all credit exposures at a given bank. As understood under Polish regulations, credit exposures constitute:

• claims outstanding (exclusive of interest),

• extended off balance sheet commitments (commitments to lend and guarantee commitments).

In the case of extended off balance sheet commitments, an additional question is whether the commitment is conditional or unconditional, as follows:

• where the commitment is conditional in character (the bank may at any time and without notice block the disbursement of funds), there is no requirement to establish specific provisions,

• where the commitment is unconditional in character (the bank is incapable of blocking the disbursement of funds), the requirement obtains that specific provisions be established commensurate to the given risk category.

The classification and provisioning system does not include other assets, in particular securities, which are valued in accordance with procedures laid down in the regulations specifying bank accounting principles.

Neither does the Polish system of prudential regulations require specific provisioning to be performed in relation to a third group of off balance sheet transactions, namely, trading transactions. This flows from the nature of these transactions. The credit risk exposure associated with them does not normally involve the notional amount, but solely price differences caused by market developments. It has been assumed that these price differences, which impact the balance sheet, are subject to capital charges under the risk-based capital ratio, and as such the associated credit risk is fully covered.

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System of specific provisioning

The specific provisioning system in force in Poland consists in two separate procedures:

• asset classification,

• determining the provision required.

Asset classification

The objective of asset classification is to assess the quality of the bank’s business environment, in this case the risk presented by its customers168. The more accurate the assessment, the better will be the information available to the bank and to banking supervision regarding the creditworthinessof banking sector customers.

Under the Polish regulatory system, asset classification, generally speaking, is based on the simultaneous application of two criteria, namely:

• an appraisal of the financial condition of the obligor,

• an appraisal of delinquency in servicing outstanding claims.

The parallel and independent application of these criteria may in some instances lead to a loan serviced on schedule being classified irregular, where the financial condition of the obligor has undergone distinct deterioration. This is perceived as an expression of the stringency of the solutions applied in Poland.

The procedures currently in force define both criteria precisely. It is noteworthy that the cut- off dates for delinquency are stricter than those employed in many other countries. These dates are set as follows:

• up to 1 month – for claims classified satisfactory and special mention,

• from 1 to 3 months – for claims classified substandard,

• from 3 to 6 months – for claims classified doubtful,

• over 6 months – for claims classified loss.

By contrast, many countries use the following classification calendar:

• from 3 to 6 months – for claims classified substandard,

• from 6 to 12 months – for claims classified doubtful,

• over 12 months – for claims classified loss.

In addition, some countries utilise the category of special mention to refer to claims that are past due from 1 to 3 months.

A direct consequence of classifying a claim as irregular is the requirement to reverse out accrued interest from the profit and loss account, and subsequently treat further interest as income in suspense. This reflects the conviction that the impairment of an asset also impairs the likelihood of realising the income associated with that asset. This approach, aside from reducing earnings by charges to specific provisions, signifies an additional lowering of earnings. It is an approach that is well-known and utilised in most prudential systems. It is worth noting that, because of this, there is no need to establish specific provisions against interest receivable on irregular loans.

A major difference in relation to the solutions in place in many other countries is that Polish regulations do not give consideration to loan security at the time of asset classification. The

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classification system is intended to provide a sound assessment of the risk present in the business environment of the banking sector, not an assessment of the risk posed to the bank (its potential losses). A weak customer should be acknowledged to be weak, regardless of the security the bank has taken. In other words, it is presumed that the furnishing of security does not in itself improve the borrower’s financial condition.

Determining the provision required

The classification of a bank’s exposures does not have a direct impact on its earnings. The bank’s earnings are not diminished by the classification findings, but by any specific provisions established.

The amount of specific provisions required is contingent not just on the classification made, but also on whether the bank holds appropriate security that mitigates the risk connected with the loan it has extended. The list of security eligible for deduction from the provisioning base is a long one in Poland, whereas international practice is to recognise mainly cash on deposit, guarantees and safe securities (e.g., Treasury or bank paper). The deduction of security from the provisioning base considerably reduces the amount of specific provisions required.

While the non-recognition of security held by the bank at the asset classification stage provides obvious analytical benefits, it also has negative consequences for the bank. This is because, where a bank has taken the highest-quality security against a claim classified irregular, it is still required to place the interest accruing in suspense, even though it would be a simple matter to recover both the principle and interest on the claim by realising the security.

In general, the initial provisioning base represents the amount of the bank’s claim or off balance sheet commitment. However, in the case of purchased debt, cheques and bills of exchange, the principle adopted is that the provisioning base constitutes the expense incurred by the bank.

The Polish system of specific provisioning sets the provision required as the following percentage of the provisioning base:

0% for exposures classified satisfactory169_,

1.5% for exposures classified special mention,

20% for exposures classified substandard,

50% for exposures classified doubtful,

100% for exposures classified loss.

These ratios are considered minimum standards. Banks are free to provision at a higher level.

The above threshold requirements for specific provisions against particular categories of exposure have been adopted in many countries. The practice of Western countries is for the level of the provision to be determined by the bank on the basis of a case-by-case assessment of the actual risk of default. In Poland (as in other countries of the region), the set schedule of provisions is mandatory. True, it is currently admissible to use bank-specific schedules for provisioning (based on credit risk models), but so far no bank has opted to do so.

Writeoffs

The picture that is given of loan portfolio quality at banks in Poland is conditioned not only by the relatively strict classification requirements in force, but also by the particular solutions concerning loss assets being removed from the balance sheet. Banks display a reluctance to write off loss assets, since the tax regulations impose a restrictive framework for recognising write-offs as a tax-deductible expense, while at the same time there are doubts as to the possibility of charging off assets against provisions without abandoning the bank’s claim or acknowledging it has lapsed.

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These circumstances result in the balance sheets of Polish banks being “weighed down” with claims classified loss, which in more liberal regimes would not be shown in the accounts at all. These issues are at present the subject of consultation between the NBP and the Ministry of Finance.