The French Banking Commission instruction No. 91-05 enforces new reporting requirements (DREP), which specify that banks must systematically downgrade to doubtful accounts any loans showing any of the following three features, including guaranteed loans:
Probable or certain risk of partial or total non recovery. In the event of an installment being more than three months overdue (for all types of credit or movable property leasing) or more than six months overdue (for real estate credits or leasing operations) Of a contentious nature (in France: warning proceedings, object of a judgement declaring legal reorganization, liquidation proceedings, personal bankruptcy, liquidation of property, legal settlement, etc.).
However, the French Banking Commission, in its note No. 92-03, allows the downgrading of loans outstanding for more than the prescribed time limits to be delayed in exceptional circumstances and subject to approval by its General Secretariat.
Furthermore, in cases where recovery of outstanding amounts becomes regular, the bank may reclassify a doubtful account as a healthy account, "even if the amount and dates of repayment are renegotiated". (see below)
The DREP also specify that banks must take the necessary action to ensure that "the classification as doubtful of a loan to a person or legal entity gives rise to the transfer of all that person or entity's healthy loans or commitments to doubtful account".
This principle (known as "contagion") applies whatever individual guarantees may exist, except "exceptional and duly substantiated cases".This is particularly the case of loans granted to real estate operators, for whom the Banking Commission will make an exception if the overall financial situation of the borrower can be considered healthy.
SPECIFIC AND GENERAL PROVISIONS
Provision for doubtful loans can be made for each individual loan (specific or appropriated provision) or for the loans as a whole (either at a flat rate or statistically). Specific provisions are set up in the amount of the risks involved, i.e. by taking account of the loan (capital, interest, accrued and due, commission due) and recovery prospects (repayments expected and calling on guarantees).
The regulations also state that:
Interest outstanding for more than three months (six months for real estate loans) must be detailed in the accounts or otherwise and fully provided for, if they are taken into income. In the case of an overall provision (capital and interest) the amount of the provision must be at least equal to that of the interest shown in the income statement.
The amount of the provision must be periodically reviewed and adjusted to take account of the development of the risk and the chances of recovery. "When all means of recovery have been exhausted for a contentious affair, and no recovery is foreseeable, the loss should be taken into account in the income statement."
French accounting doctrine also accepts that provisions can be calculated using a statistical approach. Such provisions can either replace or complement individual provisions. Use of this method is possible if the bank can substantiate it with statistics on past defaults. The actual proceeds of the loans serves as a basis for a provision covering future risks calculated by reference to statistics.
Although this approach would be difficult to apply to a general banking establishment, it could justifiably be used by banks specialised in consumer credit and home purchase credit (small amount value, numerous and homogenous credits).
In France however, tax audits sometimes question the deductibility of standard provisions on small affairs and also the deductibility of insufficiently substantiated statistical provisions. Consequently, certain French banks have abandoned these methods and reverted to specific provisions.
COUNTRY RISKS AND PROVISIONS
Country risks are defined by the French Banking Commission as "the total amount of the loans, whatever their term or nature, of private or public debtors residing in countries considered to involve risks". Loans or undertakings relative to these risks remain however under the original balance sheet headings, excepting those considered to be doubtful.
The provisioning of country risks is determined after taking account of guarantees set out by Banking Commission instruction No. 90-04 (real guarantees, guarantees given by OECD states, the World Bank group, American Treasury Bonds, etc.).
The reserve ratio is defined as the sum of provisions and below par ratings (in the case of loans acquired on the second market) brought down to the outstanding loan or commitments serving as the basis for the provision. The Banking Commission requires a rate of provision per country at least equal to the average reserve ratio of main French banks for the preceding year.
For certain types of loans, the below par rating on the second market can constitute a factor in setting the rate of provision. Lastly, these rules for country risk provisions do not exclude an additional specific provision, due to individual risks involved.
French banking regulations do not precisely define the treatment of debt restructuring, whereas they are becoming more frequent, both for country risks and individual risks. The U.S. rule FAS No. 114 defines impaired debts as being those resulting from contractual restructuring of the credit to take account of financial difficulties of the client (reduction in interest rate, respreading of payments, time extension).
It should be noted that such loans differ from doubtful loans. Hence, impaired debts remain classified as healthy assets unless a probable or certain risk remains of total or partial non-recovery of the principal.
Finally, FAS No. 114 specifies that in the case of a significant difference between the actual value of the cash flows before and after restructuring, a provision should be made for the future loss of earnings.
In this respect, the position of the Banking Commission differs, since Bulletin No. 5 specifies that only the risk of signature (i.e. the non-recovery of the capital and not a loss of earnings due to the renegotiation of a new interest rate) can give rise to a provision. This viewpoint entails therefore the recording of reduced income for the residual term of the loan (this applies particularly in the case of debt restructuring under the "Neiertz law").
From a tax viewpoint, it is furthermore impossible to restate non-productive long-term loans (or those with a low interest rate) at their actual value unless the bank can establish the likelihood of sale of the loan before its maturity for an amount lower than the nominal value.
(A separate complete note will be devoted in the near future to problems regarding real estate.)
For more information, please contact Olivier Drion or Joel Chapellier on 33 1 49 01 33 25
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.