When looking at credit quality analysis for banks reporting under IFRS, things are a little more complicated than for US GAAP banks, since there is no requirement to report current incurred losses under IFRS.
This means that when comparing reported loan loss ratios from banks, careful analysis is needed to ensure that ratios are being calculated on an equivalent basis.
Banks reporting under US GAAP typically report the loan loss ratio using net charge-offs, which captures loan losses incurred in the period. It is possible to calculate the same ratio under IFRS using information from the footnotes to the financial statements where write-offs are equivalent to US GAAP charge-offs.
The loan loss ratio typically reported under IFRS, also referred to as the asset quality ratio, is calculated by dividing the expected credit loss charge from the income statement by the average total loans.
This only tells us about the riskiness of any new loans issued and any changes in the expected level of future credit losses for existing loans, rather than losses that were actually incurred in the last period. This means that further analysis is required to gain an understanding of the level of losses that are currently being incurred.
It's also really important here to carry out detailed analysis of the notes to the financial statements, which provide a breakdown of the changes in the expected credit loss provision.
This will include increases in the provision due to changes in credit quality of the borrowers, movements between stages, and the increases in the provision for new loans.
Another ratio that can help us with the analysis of a bank's current credit quality position is the stage two to total loans ratio.
Stage two loans are those that have experienced a significant increase in credit risk since issue, and where the risk now is not low. An increase in this ratio indicates a worsening of the credit quality of the existing loan portfolio, resulting in an increasing proportion of the bank's loans being at risk of default. The non-performing or stage three loan ratio can also provide further insight here. Non-performing loans or stage three loans can be thought of as those in default.
So an increase in this ratio means that a greater proportion of a bank's loans are effectively in default.
Finally, the expected credit loss or ECL coverage ratio tells us about the link between expected losses and non-performing loans.
The expected loss provision captures the expected future losses on all loans currently on the bank's balance sheet.
Comparing this to the level of non-performing loans tells us how well current non-performing loans are covered by the provision for future expected losses.
An increase in the ECL coverage ratio could indicate either that more loans are being issued, for which the possibility of future loss needs to be accounted for, that issued loans have become more risky, increasing the current expectation of future losses, or that there has been a reduction in the level of currently non-performing loans.
Because of this, the ECL coverage ratio needs to be analyzed together with the non-performing loan ratio.
A high ECL coverage ratio and high NPL ratio indicates that the bank has lots of loans at risk of default, but it is well covered for them already.
Whereas a low ECL with high NPL ratio indicates that potential near-term losses have not been well provisioned for, which may lead to an increase in impairment expenses in the future.
