Regulatory risk reserve is kept by money deposit banks (MDBs). It is a mandatory reserve that arises from applying IFRS 9 impairment methodology on loans and advances given to clients by banks. This implies that other organization types cannot have a regulatory risk reserve in their statement of financial position.
Definition of Regulatory Risk Reserve
1. A type of statutory reserve that is kept in the books of account of a money deposit bank and appears as a line item in their statement of financial position.
2. Regulatory risk reserve is the higher prudential guideline provisioning to IFRS 9 Impairment for loans and overdrafts.
A type of statutory reserve. Regulatory risk reserve is one of the statutory reserves set aside by banks as required by the central bank of a country. The reserve is mandatory or compulsory and legally binding on MDBs to preserve in their books.
Appears in the Statement of Financial Position. You can find this fund in the statement of financial position of banks. It is located in the book’s Capital and reserve section of the financial position of banks’ annual reports. Normally, it is a separate line item on the balance sheet.
Prudential Guideline Provisioning. The Central bank makes it compulsory for banks to adjust the balance of loan clients using the prudential guideline provision. This provisioning is straightforward and so do not try to check the probability of the risk occurring. It is also simple to prepare.
Why? The Central banks already have a schedule of percentages used to calculate the provisioning. And it is applied based on the number of periods the loan has remained unpaid by borrowers. The method is used to prepare monthly statements sent to central banks by DMBs.
IFRS 9 Impairment. This is the method used in preparing impairment on loans. And it is used to reduce the loan balance in a financial statement that is made for public use. The methodology is based on 12-months expected credit loss and Lifetime Expected credit loss. The impairment loss is an expense, thereby reducing profit. Furthermore, it is used to reduce the closing balance of loans.
What to do with the differences. The use of prudential guidelines from the central bank and IFRS to calculate provisions for impairment loss gives different estimates for the same purpose. Therefore, paragraph 12.4 of the prudential guideline for money deposit banks in Nigeria states clearly that such difference should go to a regulatory risk reserve or general reserve as the case may be.
What the Prudential Guideline Says on Regulatory Risk Reserve
Paragraph 12.4 of the guideline states: “When IFRS is adopted in Nigeria, Banks would be required to make provisions for loans as prescribed in the relevant IFRS Standards.”
A. Provisions for loans recognized in the profit and loss account should be determined based on the requirements of IFRS.
However, the IFRS provisions should be compared with provisions determined under prudential guidelines and the expected impact/changes in general reserve should be treated as follows:
i. Prudential Provisions is greater than IFRS provisions; transfer the difference from the general reserve to a non-distributable regulatory reserve.
ii. Prudential Provisions is less than IFRS provisions; the excess charges resulting should be transferred from the regulatory
reserve account to the general reserve to the extent of the non-distributable reserve previously recognized.
B. The non-distributable reserve should be classified under Tier 1 as part of core capital.
What this means to Regulatory Risk Reserve
Regulatory risk reserve is created when the provisioning base on the prudential guideline is higher than that of impairment loss from IFRS. However, when the IFRS impairment is higher than the provisioning then such amount is removed from the regulatory risk reserve to the general reserve.
The fund serves to protect the bank’s capital from being eroded by losses caused by impairment of loans and overdraft. The fund is non-distributable. This means that it is not available to shareholders as dividends. It is not used to meet contingencies that may arise from business dealings. Therefore, it is preserved in the bank’s book to keep the bank strong.
Regulatory risk reserve is available in calculating capital adequacy ratio as a Tier 1 capital. This implies that a higher of this fund will increase the capital adequacy ratio of the firm.
To conclude, a regulatory risk reserve is a type of statutory reserve. It is derived from the difference between prudential guideline provisioning and IFRS impairment loss methodology. The fund helps keep the bank’s capital strength and is applicable as Tier 1 capital when calculating the capital adequacy ratio.