In theory, the loan loss provision plays a vital role in maintaining the soundness of a bank in fulfilling the intermediary function. When a bank disburses loans to customers, it will be exposed to credit risk – the risk that the borrower may not pay back the loan. To offset this credit risk, banks have to provide a credit loss provision. This provision illustrates an estimate of the expected loss of the loan. In December 2020, the absolute value of loan loss provisions for Indonesian banks was Rp304.2 trillion, an increase of 84.7 percent from Rp164,7 trillion in December 2019. The sharp increase in loan loss provisions shows that Indonesian banks expected a significant increase in credit losses.

To measure sufficient coverage on credit losses, a ratio commonly used is loan loss reserves (LLR). The nominator of this ratio is loan loss provision and the denominator is loan outstanding. LLR rose from 2.9 percent in December 2019 to 5.5 percent in December 2020. This illustrates higher appetite in loan loss coverage. Another parameter used in measuring loan loss coverage is the NPL coverage ratio, which is total loan loss provision over outstanding non-performing loans (NPL). This NPL coverage ratio in the industry increased significantly, namely from 116,09 percent in 2019 to 181,37 percent in 2020.

The Triggers

The increase in loan loss provisions in 2020 was triggered by both a macroeconomic downturn due to the Covid pandemic as well as regulatory requirements. The regulatory trigger was the implementation of IFRS 9 or PSAK 71 in Indonesia starting from January 2020.

IFRS 9 is an International Financial Reporting Standard (IFRS) published by the International Accounting Standards Board (IASB). Global implementation of IFRS 9 started 1 January 2018, while in Indonesia, the Financial Services Authority (OJK), Bank Indonesia (BI), the DAI and Ikatan Akuntansi Indonesia (IAI) decided that PSAK 71 financial instruments, the Indonesian version of IFRS 9, would be effective starting 1 January 2020.

Under IFRS 9, the definition of credit loss changes from incurred loss to expected loss, which includes forward-looking calibration based on macroeconomic variables. Moreover, for financial assets with significant increase in credit risk, although the account is still categorized as performing, the provision is calculated using lifetime expected credit losses. Therefore, this new standard has increased loan loss provision significantly.

Due to the high increase in provision calculated based on PSAK 71 compared to PSAK 55, banks were allowed to use their equity to increase the loan loss provision. However, only a few banks used the adjustment. Most banks chose to lower their profitability and increase the impairment cost to fulfill the new standard. According to the Financial Services Authority (OJK), during the beginning of 2020 when the IFRS 9 implementation started, impairment cost increased around 53 percent yoy, from Rp159,8 trillion in January 2019 to Rp246 trillion in January 2020.

The other factor triggering an increase in loan loss provision was changes in macroeconomic conditions. With the COVID-19 outbreak disrupting the economy, banks’ customers are experiencing difficulties in paying back their loans. Therefore, nonperforming loans and restructured loans have been increasing. Combined with forward-looking calibration in provision calculations, this made loan loss provisions go through the roof.

Besides an increase in NPLs, according to the OJK, restructured loans have reached Rp. 971 trillion or around 18 percent of total bank loans, including 7.6 million debtors. Restructured loans due to COVID-19 were classified as current collectability or performing assets classed as long as there are no delays of interest and/or principal payments exceeding 30 days.

Under PSAK 71, restructured loans are classified as stage 2, in which provisions should be calculated using lifetime expected credit losses. Thus, it would significantly increase loan loss provisions to be set aside by banks. Higher provisions will erode bank’s profitability and capital that would cause solvency risk for banks. To prevent this, the OJK allowed banks to classify restructured loans due to COVID-19 as stage 1, in which provision was calculated for 12 month expected loss and not lifetime. With this relaxation, banks can book lower provision than it should have and prevent losses.

Pros and Cons

In international economics, the policy trilemma or the impossible trinity states it is impossible to have all three of the following at the same time: a fixed foreign exchange rate, free capital movement (absence of capital controls) and an independent monetary policy. In banking, when a crisis arises, it is impossible (generally) to have all three of the following at the same time: sustainability, profitability, and liquidity.

As an intermediary institution, the banking industry has a significant impact on the economy. Because sustainability and liquidity are more important than profitability, increasing loan provision is one of the strategies for sustainability during uncertainty. In the course of difficult economic conditions, loan loss provision will spike as borrowers struggle to repay their debts. When the economy later stabilizes, these metrics will fall closer to their prerecession levels.

With the OJK’s relaxation, however, most banks actually chose to be conservative in anticipating credit overhang, as shown by the high growth in loan loss provisions and negative growth of their net profit. This also demonstrates that there are still elements of uncertainty in 2021.

To manage the uncertainty and drastic changes in external conditions, such as regulatory relaxation, IFRS 9 or PSAK 71 allows banks to add overlays to their provision using expert judgement, when management feels that the provision calculated by the IFRS engine is not sufficient. In this avenue, risk management plays a vital role in deciding sufficient loan loss coverage, hence, analytics and simulations are rapidly used to decide a proper number, sufficient  but not excessive.

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