Evaluating the Economic Value of Loans and the Implications:

Toward Transformation of the Business Model of Banks and Nonbank Firms

April 28, 2003
Bank of Japan

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Summary

On October 11, 2002, the Bank of Japan published "Japan's Nonperforming Loan Problem," which argued that in order to resolve the nonperforming-loan (NPL) problem a comprehensive approach is needed that centers on the "appropriate evaluation of the economic value of NPLs," "their quick disposal," and "enhancement of earning power on the part of both firms and banks."

As the Bank highlighted in this publication, appropriate provisioning based on an adequate evaluation of the impaired value of loans and the introduction of a new lending strategy based on such evaluation should be a starting point for maintaining the stability and earning power of financial institutions as well as for maintaining the stability and efficiency of the financial system. The Bank believes that the strengthening of the financial intermediary function through these measures, both at an individual institution level and for the financial system as a whole, will contribute to promoting corporate rehabilitation and creating new businesses, which will in the end lead to the revitalization of the Japanese economy.

In the 1990s, U.S. and international accounting standards began to introduce the idea of provisioning based on the evaluation of impaired value, generally calculated using discounted cash flow (DCF) or similar methods. The Basel Committee on Banking Supervision supports this method, arguing that it improves the transparency of financial institution management and strengthens credit risk management capacities. Studies are now underway towards the introduction of a more widely applicable DCF method known as "recognition of collective impairment."

The United States has already established a framework that encourages financial institutions to speedily respond to NPLs. There are two main facets: (1) provisioning practices that require appropriate reflection of the economic value of a loan; and (2) a bankruptcy law system that is oriented towards corporate rehabilitation. As a consequence, financial institutions now take steps to rebuild businesses before the credit quality of borrowers deteriorates and their own losses expand. The result has enabled borrower corporations to smoothly transform their businesses at an early stage in response to changes in competition and advances in technology, and this is one factor on the financial side facilitating transformation of industrial structure.

In Japan, provisioning rules have seen steady improvement over the past several years. In addition, during the first quarter of 2003 large Japanese banks began applying the DCF method to loans to large borrowers that "need special attention." The significance of the introduction of the DCF method in Japan goes beyond the mere improvement of provisioning methods. It can be seen as an important trigger that will lead to appropriate evaluation of the economic value of loans and the provisioning of appropriate reserves for them, changing traditional lending practices and accelerating business rebuilding, with the ultimate result of changing the business models of banks and firms alike.

However, taking full advantage of the implications of the DCF method will require new management efforts on the part of financial institutions to enhance their internal management accounting in ways that acknowledge and utilize the principles of economic valuation. There will be three facets to this: (1) introduction of loan screening procedures that emphasize the cash flow generation capacity of borrowers; (2) introduction of a lending framework that allows institutions to respond to risk profile changes, for instance, the attachment of covenants to loan contracts; and (3) strengthening "workout" departments to better enable them to deal with NPLs and providing a system of incentives for doing so.

Another important task for Japan in developing a loan management and provisioning framework will be to deepen studies of methods to capture the aggregate economic value of groups of loans (recognition of collective impairment). With such methods in place, it will be easier to capture economic value even for loans where it is difficult to estimate individual cash flow. This method will also reduce credit risk management costs and improve credit risk management efficiency.

Obviously, lending practices and business models are built up over many years by the institutional complementarity of various systems and practices. These are not easy to change. Improvements in the provisioning rules must be accompanied by review of the bankruptcy framework, enhancement of secondary markets for loan assets, development of the corporate turnaround business, and a wide range of other efforts. Evaluating the economic value of loans would provide a foundation for achieving these aims.

The Bank of Japan will use its examination and monitoring functions to verify the appropriateness of provisioning under the newly-introduced DCF method at large banks and the extent of its application in internal management. The Bank will also continue its theoretical and practical studies of the DCF method in order to further develop the method in an ongoing dialogue with all related parties.