Single Supervisory Mechanism and corporate finance: A DSCR based approach for AQR prudential provisioning

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Abstract

Asset quality review (AQR) conducted by the European Central Bank (ECB) introduced 2014 indicators and logic typically used in the context of corporate finance. The new approach tries to overcome the backward-looking approach in favour of a completely forward-looking perspective based on the assessment of cash flows. From the AQR point of view, EBITDA and DSCR have taken particular importance also in the prudential provisioning process. As is known, the AQR manual, for calculating the prudential provisioning, provides that banks, in a going-concern perspective, estimate the recoverable amount of loans by appropriately discounting the cash flows. Our work, although under some hypotheses, highlights limitations in the prudential regulatory approach. The paper, using a DSCR-based dual-leg approach, tries to propose a generalisation logically consistent with the guidelines on loan origination and monitoring recently expressed by the European Banking Authority (EBA) (EBA, 2020). Although there is literature dealing with access to credit constraints (Demirgüç-Kunt & Maksimovic, 1999; Beck & Demirgüç-Kunt, 2008; Calabrese, Girardone, & Slip, 2020), with the relationship between credit risk management framework and accounting standard (Porretta, Letizia, & Santoboni, 2020) and with loan loss coverage policies (Alessi, Bruno, Carletti, Neugebauer, & Wolfskiel, 2020), no empirical or theoretical research analyses the relationship between prudential provisioning and underlying incentive structure. This paper offers a contribution in this regard highlighting how an economic approach for provisioning tends to reward companies capable of generating adequate prospective cash flows given the contractual structure of the loan, thus mitigating the potential allocative distortions implicit in the incentive structure underlying the AQR approach.

Keywords: Provisioning, Debt Service Coverage Ratio, IFRS 9, Corporate Finance, Forward-Looking, Stochastic Model

Authors’ individual contribution: Conceptualization — E.G. and M.P.; Methodology — M.P.; Software — M.P.; Validation — E.G. and M.P.; Formal Analysis — M.P.; Investigation — M.P.; Resources — L.J.; Data Curation — L.J.; Writing — Original Draft — M.P.; Writing — Review & Editing — L.J.; Visualization — L.J.; Supervision — E.G. and M.P.; Project Administration — M.P.; Funding Acquisition — E.G. and M.P.

Declaration of conflicting interests: The Authors declare that there is no conflict of interest.

Acknowledgements: The authors would like to thank Prof. Andrea Molent for his contribution to the analytical development of the paper.

JEL Classification: L51, G17, G21, G38

Received: 14.02.2021
Accepted: 05.05.2021
Published online: 06.05.2021

How to cite this paper: Geretto, E., Polato, M., & Jones, L. (2021). Single Supervisory Mechanism and corporate finance: A DSCR based approach for AQR prudential provisioning. Risk Governance and Control: Financial Markets & Institutions, 11(2), 47–57. https://doi.org/10.22495/rgcv11i2p4