Expected loss, provisions and the shortfall · RiskAtoms Academy

By the end you will be able to

1Explain why IRB capital leaves out expected loss, and compare regulatory EL with IFRS 9 provisions.
2Work out an EL shortfall or excess, and say where each goes: CET1, Tier 2 or nowhere.
3Treat a defaulted loan under F-IRB, A-IRB and the standardised approach.
4Describe the IFRS 9 transitional relief and how it was phased out.

Why it matters

RiskAtoms Bank plc's IRB loans are expected to lose £97.3m in a year. Its accounts already hold £179.4m of provisions against them. The extra £82.1m looks like a cushion, and the rules let it count as capital, but only £74.8m of it, and only as Tier 2. The other £7.4m counts for nothing. Had the provisions been short of EL, the gap would have come straight out of CET1.

Core explanation

Two measures of the same loss

Illustrative dataRiskAtoms Bank plc's capital book

The same made-up UK bank as Level 3: £67bn of assets and £4bn of equity at 31 December 2025, in £ millions. Module 4.1 adds its regulatory layer: own funds, deductions, risk-weighted assets by risk type, buffers, the leverage exposure and MREL, computed from the Level 3 credit, trading, derivatives and operational risk books. Every figure is illustrative, not any bank's data.

Pro forma. The book applies Basel 3.1, the 2017 finalisation of Basel III, to the 31 December 2025 balance sheet. On that date the bank still reported under the old UK CRR. The UK applies Basel 3.1 from 1 January 2027, and the internal model approach for market risk from 1 January 2028 (PRA PS1/26, paras 1.23 and 1.24). So the book shows the bank as it would look under the new rules.

The credit figures are the Level 3 credit book (Module 3.3): its twelve corporate borrowers and three mortgage segments, each scaled up to stand for a slice of the bank's £12bn corporate and £30bn mortgage books. Grades, PDs and LGDs are unchanged.

EL and provisions

The IRB formula of L4.2.05: The IRB risk-weight formula gives capital for unexpected loss only. Expected loss is meant to be covered already, by provisions. So IRB banks must check that it is (CRE35.1). Two measures meet:

Regulatory EL: PD × LGD × EAD, the expected value of L3.3.10: Expected loss (M-C02: Expectation), over one year with downturn LGDs. Slotted loans use the EL risk weights of L4.2.06: IRB for retail and specialised lending.
Eligible provisions: the IFRS 9 expected credit loss of L3.3.18: Provisioning basics: 12 months for stage 1, lifetime for stage 2 and 3, point in time.

The comparison is in total, across the IRB book, not loan by loan (CRE35.8). For this bank:

IRB portfolio	EL	Eligible provisions	Provisions − EL
Corporates (F-IRB)	69.4	151.7	82.3
Mortgages (retail IRB)	27.9	27.7	−0.2
Total	97.3	179.4	82.1

The mortgages are provided at about their EL. The corporate excess comes from the stage 2 names, the ones on the watchlist of L3.3.17: Early warning, watchlists and workout. Their lifetime provisions are £84.2m above their one-year EL, while the stage 1 names together are £1.9m short:

Corporate	IFRS 9 stage	EL	Provision	Provision − EL
Thornvale Engineering Ltd	1	1.35	1.12	−0.23
Bramwick Stores plc	1	8.71	9.47	0.76
Pellcourt Properties Ltd	1	3.81	1.82	−1.98
Ostreth Energie GmbH	1	1.09	0.96	−0.13
Larkhollow Freight Ltd	2	5.58	15.39	9.81
Mirefield Care Homes Ltd	2	3.30	11.84	8.55
Quorrel Systems BV	1	2.00	1.88	−0.12
Hastemoor Construction Ltd	2	10.93	27.88	16.94
Vellacourt Hôtels SAS	2	5.82	19.83	14.02
Cindral Pharma Inc	1	0.37	0.31	−0.06
Graybeck Plastics Ltd	2	25.33	60.22	34.88
Sallowmere Logistics GmbH	1	1.10	0.95	−0.15
Corporates		69.4	151.7	82.3

A shortfall comes off CET1

If total EL is above total provisions, the shortfall is deducted from CET1 in full, and the tax a larger provision would have saved does not reduce the deduction (CAP30.13). This bank has none. Suppose it had provided only the 12-month ECL on every corporate, as if none had moved to stage 2: its provisions would be £96.2m against EL of £97.3m, a shortfall of £1.1m. That comes off CET1, and the Tier 2 excess of £74.8m would be gone.

An excess counts in Tier 2, up to a cap

If provisions are above EL, the excess may count in Tier 2 up to 0.6% of IRB credit RWA (CAP10.19, CRE35.9). The cap is a minimum of two values (M-A11: Min, max, floors and caps): 0.6% × 12,461.0 = £74.8m, below the £82.1m excess. So £74.8m counts and £7.4m is lost: total capital is £3,994.7m, a ratio of 17.51% instead of 17.55%. Banks on the standardised approach have a parallel rule: general provisions count in Tier 2 up to 1.25% of credit RWA (CAP10.18).

Sort itWhere does it go?

For each amount at an IRB bank, choose where it ends up in the capital calculation.

Total EL is £30m more than total eligible provisions
Provisions exceed EL by £50m; 0.6% of IRB credit RWA is £70m
The part of an excess above 0.6% of IRB credit RWA
General provisions on an SA book, below 1.25% of its credit RWA
A specific provision on a defaulted SA loan

Defaulted loans and BEEL

Once a borrower defaults, its PD is 100% and the question is only how much more will be lost. Suppose Graybeck Plastics Ltd, the bank's weakest name, defaulted with £298.6m outstanding and a provision of £227.6m (76%):

Approach	How	K or RW	RWA	EL
F-IRB	EL uses the supervisory LGD, 75% for a subordinated loan (CRE35.3), so K = max(0, LGD − EL) = 0	0%	0.0	224.0
A-IRB	K = max(0, LGD − BEEL) = 83% − 75% (CRE31.3)	8%	298.6	224.0
Standardised	Net of the provision, 100% because provisions are at least 20% of the outstanding	100%	71.0	–

Under both IRB approaches the EL of £224.0m joins the comparison with provisions, where the £227.6m provision covers it. Under A-IRB the best estimate of expected loss is the bank's own; the gap between LGD and BEEL is capital for the chance that recoveries turn out worse during the workout. Before default the loan carried £1,005.0m of F-IRB RWA. The two EL figures match only because the bank's assumed BEEL, 75%, happens to equal the supervisory LGD for a subordinated loan, 75%: one is the bank's own estimate, the other a fixed rule.

IFRS 9 and the transitional relief

IFRS 9 replaced incurred losses with expected losses from 2018, and stage 2 brought lifetime provisions forward. To soften the hit to CET1 the Basel Committee allowed transitional relief: a bank could add back part of the rise in its new provisions, for at most five years, phased out on a straight line (CAP90.8, 90.13 to 90.14). For an IRB bank, the add-back must take account of the EL comparison, since provisions that only fill a shortfall were already off CET1 (CAP90.12).

An illustration, not in the book: suppose a new standard raised the bank's provisions by £60m on its standardised book and £40m on the IRB book. At a 25% tax rate CET1 falls by £75m. The IRB part does not help Tier 2: the excess is already above the cap. A straight-line add-back would run:

Year	Add-back factor	Added back	CET1 effect
1	80%	60.0	−15.0
2	60%	45.0	−30.0
3	40%	30.0	−45.0
4	20%	15.0	−60.0
5	0%	0.0	−75.0

The CET1 ratio of 13.24% would fall to 12.91% with the full hit, and to 13.18% in year 1 with the add-back.

The formal version

For the IRB book (CRE35.3, 35.8 to 35.9; CAP10.19; CAP30.13):

\begin{aligned} \text{EL} &= \sum_{i \notin D} \text{PD}_i \cdot \text{LGD}_i \cdot \text{EAD}_i \;+\; \sum_{i \in D} \text{BEEL}_i \cdot \text{EAD}_i \;+\; \sum_{j \in S} 8\% \cdot \text{RW}^{\text{EL}}_j \cdot \text{EAD}_j \\ \text{Shortfall} &= \max(0,\ \text{EL} - P), \qquad \text{deducted from CET1} \\ \text{Tier 2 add} &= \min\big(\max(0,\ P - \text{EL}),\ 0.6\% \cdot \text{RWA}_{\text{IRB}}\big) \end{aligned}

$D$ : defaulted exposures; $S$ : slotted exposures, with the EL risk weights of CRE33.9. Under F-IRB, $\text{BEEL}$ is replaced by the supervisory LGD.
$P$ : total eligible provisions on IRB exposures (CRE35.4). $\text{RWA}_{\text{IRB}}$ : credit RWA under IRB.
Defaulted A-IRB exposures: $K = \max(0,\ \text{LGD} - \text{BEEL})$ (CRE31.3).

Try it

Start at the bank's book. Hold the provisions and raise EL to 200: the shortfall of £20.6m comes off CET1 in full, and the CET1 ratio falls from 13.24% to 13.15%. Lowering the provisions instead releases them through profit and loss, so CET1 rises, and is highest where provisions equal EL. Then raise the provisions: see the Tier 2 excess stop at the cap, while CET1 keeps paying for each extra £1 of provision through profit and loss.

Try itExpected loss against provisions

Eligible provisions on the IRB book, £m179.4

Expected loss on the IRB book, £m97.3

Shortfall, deducted from CET1£0.0m

Excess of provisions over EL£82.1m

Tier 2 cap, 0.6% × 12,461£74.8m

Excess counted in Tier 2£74.8m

Excess not recognised£7.4m

Provision change through P&L, after tax+0.0

CET1£3,019.9m (+0.0)

Total capital£3,994.7m (+0.0)

CET1 ratio13.24%

Total capital ratio17.51%

An excess above the cap: only 0.6% of IRB RWA counts in Tier 2. The rest is not recognised anywhere.

Starts at the bank's IRB book: provisions £179.4m, EL £97.3m. Raising provisions costs CET1 through P&L at a 25% tax rate (assumed); changing EL alone does not. RWA are held fixed. Illustrative.

Worked example

The bank's EL, provisions and capital

The IRB book at 31 December 2025, £ millions. EL is from the IRB inputs of L4.2.05: The IRB risk-weight formula; provisions from the IFRS 9 stages of L3.3.18: Provisioning basics.

From EL to total capital

Step 1 of 6

1
Total EL
$\text{EL} = 69.4 \ \text{(corporates)} + 27.9 \ \text{(mortgages)} = 97.3$

Mortgage segment	EL	Provision	Provision − EL
LTV up to 60%	1.73	1.73	0.00
LTV 60–80%	9.45	9.27	−0.17
LTV 80–95%	16.73	16.73	0.00
Mortgages	27.9	27.7	−0.2

The mortgage provisions are the segments' 12-month EL; the 60% to 80% band's EL also includes mortgage offers at a 40% CCF, which carry no provision. The comparison nets this against the corporate excess.

Regulatory lens

The EL comparison is CRE35; the capital treatment CAP10.18 to 10.19 and CAP30.13; the transitional relief CAP90. Statements on jurisdictions are as at 3 November 2026 as at 3 Nov 2026.

In the UK

UK CRR Article 473a ran the IFRS 9 relief with two parts. The static part, on the day-one rise, was added back at factors of 70%, 50%, 25%, 0%, 0% for 2020 to 2024. The dynamic part, on later rises in stage 1 and 2 provisions, was given new factors by the 2020 quick fix for rises from 1 January 2020: 100% in 2020 and 2021, 75% in 2022, 50% in 2023 and 25% in 2024 (PRA statement, 30 June 2020). On the illustration that would add back £75m in each of the first two years. The relief ended on 31 December 2024.

In the EU

Regulation (EU) 2020/873, the CRR quick fix, set the same dynamic factors for provisions raised from 1 January 2020: 100%, 100%, 75%, 50% and 25% for 2020 to 2024, with full phase-out from 2025 (Cleary Gottlieb, 2 July 2020).

In the US

US banks use CECL rather than IFRS 9. The agencies' 2020 rule let banks adopting CECL in 2020 delay its capital effect for two years, using a 25% scaling factor for the extra provisions, followed by a three-year phase-in: “a five-year transition period in total” (85 FR 61577, 30 September 2020).

Spark Atoms

Spark AtomWhy not let the excess count in CET1?

A provision is already a charge against profit: an excess means the bank has recognised more loss than the regulatory measure expects. Counting it as Tier 2, and capping it, stops a bank with generous provisions from inflating its capital by much. On this bank the cap costs 0.03% of total capital ratio.

Spark AtomTwo clocks

EL looks one year ahead with downturn LGDs; IFRS 9 looks one year or a lifetime ahead, point in time. In a downturn, provisions can jump as loans move to stage 2, while through-the-cycle PDs move more slowly. So the excess tends to grow in bad years, just when the cap stops the extra from counting.

Key takeaways

IRB capital covers unexpected loss; expected loss must be covered by provisions, so IRB banks compare total EL with total eligible provisions.
A shortfall is deducted from CET1 in full, with no tax relief.
An excess counts in Tier 2 up to 0.6% of IRB credit RWA. This bank: £82.1m excess, £74.8m counted, £7.4m lost.
Defaulted loans: F-IRB K is zero with EL at the supervisory LGD; A-IRB K = max(0, LGD − BEEL).
IFRS 9 transitional relief added back part of the new provisions to CET1 for at most five years; in the UK and EU it ended with 2024.

Reaction

Check what stuck

Question 1 · objective 2

An IRB bank has total EL of £120m and eligible provisions of £100m. How much is deducted from its CET1, in £m?

£m

Question 2 · objective 2

A bank has IRB credit RWA of £10,000m and provisions £80m above its EL. How much counts in Tier 2, in £m?

£m

Question 3 · objective 3

A defaulted A-IRB loan of £100m has LGD 45% and a best estimate of expected loss of 40%. What are its RWA, in £m?

£m

Question 4 · objective 1

Why do the bank's stage 2 corporates hold provisions well above their regulatory EL?

ATheir provisions cover lifetime expected loss, while EL is a one-year figureBRegulatory EL ignores LGDCStage 2 loans have a PD of zeroDProvisions on stage 2 loans are scaled up by 1.06

Question 5 · objective 4

What did the IFRS 9 transitional arrangements do?

AAdded back to CET1, for a few years and on a falling scale, part of the rise in provisions from the new standardBLet banks ignore IFRS 9 in their published accountsCRemoved the EL shortfall deduction permanentlyDRaised the Tier 2 cap on excess provisions from 0.6% to 1.25%

Glossary

Regulatory expected loss: Regulatory expected loss (EL): PD × LGD × EAD on each non-defaulted IRB exposure, a one-year, through-the-cycle figure with downturn LGD (CRE35.2 to 35.3; CRE36.63 and 36.83 for the long-run PD and downturn LGD).
Eligible provisions: Eligible provisions: the accounting provisions on IRB exposures that count against EL: specific and general provisions, partial write-offs and discounts on defaulted assets bought (CRE35.4).
EL shortfall: EL shortfall: the amount by which total EL exceeds total eligible provisions. Deducted from CET1 in full.
Excess provisions: Excess provisions: the amount by which eligible provisions exceed EL. Counts in Tier 2 up to 0.6% of IRB credit RWA.
BEEL: Best estimate of expected loss (BEEL): an A-IRB bank's estimate of the loss still expected on a defaulted exposure, given current conditions and the provisions already made (CRE36.86).
Stage 2: Stage 2 (IFRS 9): a loan whose credit risk has risen significantly since it was made. Its provision covers lifetime expected loss, not just 12 months.
Transitional relief: Transitional relief: a temporary add-back to CET1 of part of the rise in provisions from a new accounting standard, phased out over at most five years (CAP90).

Deep Dives & Origins

Deep Dives

Basel Committee on Banking Supervision, CAP90: Transitional arrangements: the IFRS 9 relief, including the 2020 amendments. Intermediate.
L3.3.18: Provisioning basics: how IFRS 9 stages and lifetime ECL work. Foundation.

Origins

Basel Committee on Banking Supervision, CRE35: IRB approach: treatment of expected losses and provisions, paras 35.1–35.9, version effective 1 January 2022, bis.org.
Basel Committee on Banking Supervision, CRE31, para 31.3; CRE36: IRB approach: minimum requirements to use IRB approach, paras 36.63, 36.83 and 36.86; CAP10: Definition of eligible capital, paras 10.18–10.19; CAP30: Regulatory adjustments, para 30.13; CAP90: Transitional arrangements, paras 90.8–90.18, bis.org.
Regulation (EU) No 575/2013 as it applies in the UK, Article 473a, legislation.gov.uk; Prudential Regulation Authority, statement on the CRR quick fix, 30 June 2020.
Cleary Gottlieb, CRR Quick Fix to Facilitate Lending in Response to COVID-19 Adopted, 2 July 2020.
OCC, Federal Reserve Board and FDIC, “Regulatory Capital Rule: Revised Transition of the Current Expected Credit Losses Methodology for Allowances”, 85 FR 61577, 30 September 2020.

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