The Expected Credit Loss of Covid-19

The model for the calculation of countercyclical capital buffers has recently transitioned from incurred to expected losses. Whether the latter model helps reduce pro-cyclicality and better prepares banks for economic downturns is much debated because it implies a sudden and substantial impairment on banks’ portfolios when the economy switches from expansion to contraction. We use the contraction caused by the Covid-19 crisis to compare the two accounting models. The hypothesis tested is that the most desirable economic outcome is obtained when banks switch from one model to another contingent on the phase of the economic cycle. However, the possibility of requiring banks to transition to expected loss models is at odds with the powers given to supervisors under the European Single Supervisory Mechanism. Our analysis of the Covid-19 impact on banking tackles a long-standing legal debate over where to set the boundary between accounting freedoms and supervisory powers.