The EU's banking watchdog warned on Friday that banks would face challenges from regulators for their improper use of an accounting regulation meant to ensure that their provisioning for soured loans is adequate and timely.

The European Banking Authority (EBA) noted that the same flaws as its first assessment were found in its second study on the IFRS 9 norm, which was created in response to a key lesson learned from the 2008 global financial crisis.

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A bank must test its loans against going market values, recognize a percentage of any "expected" loss over the next 12 months, and make upfront provisions for this according to IFRS9, a worldwide accounting standard.

When there is a substantial rise in credit risk, which increases the possibility that the loan will default, full provisioning is required.

Regulators find it more difficult to assess whether banks have made enough provisioning and, ultimately, have the requisite capital levels when the rule is not correctly applied.

The EBA's conclusions are released at a time when some borrowers are having trouble paying their loan payments due to the sharp increase in interest rates following record lows.

It said that supervisors in EU states will investigate the key conclusions.

According to the analysis, there are a lot of "adjustments" or "overlays"-banks utilizing their discretion to modify the outcomes of their risk models-which might cause a delay in the transition to full provisioning.

According to the EBA, banks were also too hesitant to do so-called "collective" risk assessments of a portfolio of loans when the risk information for individual loans was too hazy.

It stated that this was a "concern from a prudential perspective". It also stated that there is a need to improve "backtesting," or tests of the accuracy of applying IFRS 9 to determine whether projected loss models require recalibrating.

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European Banks Signal Concerns Over Rising Bad Loans Amid Global Economic Challenges

In July, Europe's major banks, including Deutsche Bank (DBKGn.DE) and Lloyds Banking Group, on Wednesday pointed to the rising risk of bad loans as the global economy struggles with slow growth and high inflation.

Financial regulators and investors are keeping a close eye on how banks navigate the uncertain economic climate and are looking in particular for any signs of stress in banks' loan books.

The most recent wave of bank profits in Europe brought to light more general patterns in the global banking industry, such as the strain on investment banks from a lack of deals and the support that higher interest rates are providing for retail bank profitability.

Amidst the financial strain caused by Britain's economic downturn, Lloyds incurred more costs for problematic loans and failed to meet first-half profit targets, which increased pressure on management to provide additional support to depositors.

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