I have a very specific query which requires a specific answer. If a bank recognizes revenue on a time apportioned basis over the life of the mortgage and the mortgage rate is say 7% p.a. If the bank reduces the mortgage rate from 7% to 4% what will be the effect to its P&L. The bank's finance division states that they will have to make provisions to the P&L because the revenue has been booked upfront. Is this possible?? So these are my queries:1. How does revenue recognition on mortgages on a time apportioned basis work?2. Will the bank have to make a PROVISION to P&L if it reduces the rate from 7% to 4%?3. What is the solution (apart from changing the accounting policy) to prevent taking a hit to P&L if the bank reduces the rate from 7% to 4%?
Hello and welcome...
I would request you to kindly remain online while I prepare your reply and see if I can help.
Hello, sorry to keep you on hold.
This is now a concept of revenue recognition on mortgage OR for that any matter / loan, it would work like.
In such kind of revenue recognition, the cash of the profit is realized and taken out BEFORE it is materialized.
Conventional accounting practice allows revenue to be recognized and so profit to be taken before cash is received - provided that it is reasonably certain that the revenue will be received. (The Mortgage payments will have "Interest" component which is a profit for the bank)
This consideration requires considerable judgement and sometimes imprudent decisions are taken Recognizing revenue only when the client/customer has no further claim on the seller or provider is normally regarded as being unnecessarily prudent
Also note that accounts, in most of the cases, are not normally prepared on a cash flow basis and it is not normal practice to adopt an entirely arithmetic approach to determine when and how much revenue should be recognized in the accounts.
Having said this, coming to the second part of your question,
YES.. the bank is correct when it says that it will have to make a PROVISION, in the interest rates.
This is because, any reduction in the interest rates charged would bring down the Net Interest Income (i.e. income from operations) and this would happen KEEPING ALL OTHER THINGS AND FACTORS UNCHANGED AND CONSTANT.. So, a provision has to be made.
Coming to the third part of your question...
There can be some qualitative measures that banks can adopt, either to completely mitigate or at least partially mitigate their risks of taking hit on the P&L Accounts.
Some of the things the banks can do is to reduce THEIR cost of funds. They should try and get funds more cheap so that they can mitigate some of the risks.
They may have to attend their NPAs (Non-Performing Assets) or their loans which are behind and delinquent. This will improve the overall asset quality and reduce the provisions that they make for such bad loans.
They should also reduce their Deposit rates -- i.e the rates that it pays to the people / investors whose money they hold in the deposit accounts. Further they may see if some operational charges can be hiked, etc.
All these "Collective" measures can help the banks fully mitigate OR AT LEAST partially mitigate the risks of the dent in the P&L account from reduced interest rate and subsequently reduced net interest income.
Hope this helps.. You may use "CONTINUE CONVERSATION" to revert with additional queries if you have. Rate this answer ONLY IF you are done with this and if this helps and satisfies you.
Hello, I see you standing by.. Are you there ?
Our chat has ended, but you can still continue to ask me questions here until you are satisfied with your answer. Come back to this page to view our conversation and any other new information. What happens now? If you haven’t already done so, please rate your answer above. Or, you can reply to me using the box below.
Hi Rakhi, many thanks. One more query...the bank in question is an Islamic bank from the Middle East. Does the same apply to Islamic banks? Particularly when taking into account the solution to the problem?
Dear Friend,As I believe, Islamic banks do not work for profit or they do not charge interest as this is against some of the religious beliefs. They method of earning is different.. or rather, let me put it correctly-- their method of "sharing" is different.HOWEVER, the concept and principles to work in order to avoid any hit on the P&L Account would remain more or less the same.Hope this helps.. You may use "CONTINUE CONVERSATION" to revert with additional queries if you have. Rate this answer ONLY IF you are done with this and if this helps and satisfies you.Warm Regards,
Graduated in law with Emphasis on Finance and have have been working in financial sector for over 8