• The adoption of International Financial Reporting Standards 9 (IFRS 9) from January 2018 will change how accountants have been dealing with credit losses. 
• Accountants are forced to adopt forward-looking complex models to calculate expected losses and ensure they have sufficient buffers in their loss provisioning. 
• IFRS 9 brings accounting to the frontiers of risk management and the future will see a convergence between the two disciplines

The financial crisis of 2008 highlighted some key shortcomings of accounting practices, most of which were then governed by IAS 39 standards. As a result, shortly after the crisis unfolded, the leaders of the G20 group of nations issued a statement calling for a more robust set of amended accounting standards for the purposes of strengthening the global financial markets and participating institutions. 

The IAS 39 model was criticised for a variety of factors with the key ones centered on the “incurred loss model” which was deemed too backward looking and thus blamed for delaying the recognition of losses during the financial crises. Additionally, the complexity of having multiple impairment approaches made it challenging for accountants and controllers to fully understand the concepts and apply them accurately during a crisis period.

What is IFRS 9?
IFRS 9 is a combination of old accounting standards as well as the new proposals that were highlighted to the G20 by The International Federation of Accountants (IFAC) at the G20 2009 meeting in London during the financial crises. The recommendations broadly called for a reduction in the complexity of accounting standards for financial instruments as well as proposals to strengthen accounting recognition of loan-loss provisions.

These new proposals were then added to existing standards and the final version was published in July 2014 that included revised guidance on the classification and measurement of financial assets, as well as new impairment guidelines along with a more robust framework for hedge accounting rules.
The mandatory deadline for implementing the above version of IFRS 9 is set at 1 January 2018.

A forward-looking model
The main challenge of IFRS 9 comes from it’s newly impairment standards which no longer relies on a loss event to occur before such an impairment loss is recognised. The key difference is that accountants and controllers will now be forced to adopt forward looking models in determining how expected losses will arise during the life time of the loan. These impairment models will require institutions to anticipate future expected credit losses in profit or loss for financial assets and exposures, whether newly originated or acquired through purchase, participation or assignment.

The first step entails an institution to look at “expected credit losses”. An example of this would mean that institutions now would be compelled to figure out if all the loans in the portfolio will be repaid in time. In the event that this is not likely to occur, institutions will have to estimate when the outstanding would be recovered. It also involves calculating how much of the loan can be recovered in the event of a default.

The next step is to determine at which point would there be a significant increase in credit risk for the loans. For measurement purposes, it is very important that institutions clearly understand and define the term “significant increase”.

The three-stage approach
IFRS 9 likes to draw a clear distinction between those assets that have shown no deterioration in credit in the short run and therefore can be bucketed as more sound and therefore “performing”, as opposed to assets that have shown some form of credit deterioration.

This means that IFRS 9 likes to bucket all assets into three categories. The first bucket consists of performing assets which are usually placed into the “12-month expected credit losses” bucket whereas the underperforming assets go into the “lifetime expected credit losses”. An asset moves from the “12-month expected credit loss” bucket to a lifetime expected credit losses bucket when there is a significant deterioration in credit quality over the first 12 months.

“Lifetime expected credit losses” are the expected losses that arise when taking into account the potential for default at any point during the life of the financial instrument.

The third category is reserved for the non-performing assets. This is usually the category where assets have displayed evidence of credit deterioration at initial recognition. The treatment for the third category is the same as the second category in that the assets get placed under the “lifetime expected credit losses” bucket but the only difference being that calculation of interest revenue for the third category is lower as IFRS 9 rulings ensure that expected interest to be received is reduced for the greater expected credit losses in the future (Figure 1).

Source: KPMG

Calculation of the estimated expected loss is not overly complex but does need a significant amount of data, including historic data as it requires entities to look at past events and behaviour of similar financial instruments, along with being able to forecast conditions that may impact the receipt of future cash flows of such instruments.

Impairment and balance sheet challenges
The immediate impact of IFRS 9 will be on the bank’s balance sheet as the change in impairment standards will force banks to have a loss provision on their balance sheets for expected losses in the future, instead of actual losses already suffered.

During the financial crises, when banks realised that credit deterioration was taking place within some of their counterparties, the risk management division would enforce several risk mitigation measures such as limits on volumes or increased haircuts on their collateral. By contrast, finance departments would helplessly watch as accounting practices only allowed them to book losses when the losses had actually occurred. Therefore by allowing for a more dynamic monitoring of credit health over the lifetime of the exposures, banks will be able to adjust their loss provisions more accurately to the underlying change in risk of the assets and thereby ensuring they are adequately capitalised for the risks they are taking. However, this also means that balance sheets for banks would be negatively impacted with the increased loss provisions due to the new impairment rules.

According to report released by IFRS in 2015, “the majority of large banks surveyed expect balance sheet allowance to increase at the first application of IFRS 9. Many expect the loss allowances to increase by 50%.”

CET 1 or tier 1 capital represents a bank’s health. An increase in the loss provision will negatively impact capital ratios. Although provisions for loans are normally under tier 2 capital, which has a ceiling, the remainder would flow to tier 1 capital. A study by Deloitte has found that banks’ capital ratios will deteriorate as a result of IFRS 9 implementation. “They are expecting core tier 1 capital to decrease on average by 0.5% as a result of moving to IFRS 9”, according to the Deloitte report.

The most obvious impact of tier 1 capital decreasing means banks have to reduce their risk weighted assets (RWA) in order to maintain their CET 1 ratio and this in turn involves either cutting the trading exposures or reducing the assets. At a time when Basel III capital regulations on capital, funding and leverage are already limiting a bank’s ability to do business with their clients, IFRS 9’s impairment is yet another regulation that will cause some banks to reduce their existing exposures to clients.

Can banks leverage off Basel III models?
A key question banks have been asking is whether they can rely on leveraging off the Basel III framework of credit modeling. Under Basel III, banks already have an existing approach for calculating the regulatory capital required (RWA) for their credit exposures. To calculate capital requirements, three main risk parameters are necessary for measurement: probability of default (PD), exposure at default (EAD) and loss given default (LGD). These are the same inputs required to calculate expected credit losses under IFRS 9’s impairment standards.

While the parameters between IFRS 9 and Basel III are similar, the central issue is that the approach of calculating default is different. IFRS 9’s impairment standards were created for the precise reason of calculating the probability of default (PD) at any point in time during the life of the economic cycle. This means that IFRS 9’s PD is highly sensitive to changes in the economic cycle. By contrast, regulatory models that calculate RWA under Basel III adopt a “Through the Cycle Approach” which means taking a longer term view. This is because Basel III regulators prefer to have regulatory capital modeling to be less volatile and hence are adverse to short-term adjustments that arise from economic conditions. Also Basel III regulators prefer that banks “hold more capital” during strong economic periods which is contradictory to IFRS’ “point in time” approach which allows capital to be adjusted downwards during good times.

The result of not being able to use Basel III’s regulatory capital framework, means that banks essentially may have to dedicate time and resources in rebuilding on their Basel III models and incurring significant costs on both technology and operational processes for developing IFRS 9 capabilities.

Implementing IFRS to meet the deadline
Deloitte’s survey of IFRS 9 in 2016 included 91 banks globally and focused on a key question of readiness for IFRS 9 by the deadline. The results were not encouraging. Close to 50% of the respondents believe that “they do have enough resources to deliver changes by the 2018 implementation date”.

Andrew Martin, a former head of risk technology at AIG and currently advising banks on IFRS 9 implementation as a consultant for Fairlight Capital, said: “Banks are making significant changes to their data, modeling and IT infrastructure in order to meet the challenge of calculating forward-looking loan loss estimates by 1 January 2018. The real challenge is not really dealing with new standards but more in looking at the integration of risk and finance as one. What institutions need to do is to combine risk model outputs with accounting data and systems, and this requires a lot of transformation work internally.”

Implementing IFRS 9 is not only about building the right model. Another key component involves applying the right data to all the existing portfolios once they are in scope for IFRS 9. The purpose is to ensure that there is enough historical data to model future behaviour. In addition, processes will have to be created around impairment modeling, calculation and forecasting and once this is done, controls will have to be set around these processes (Figure 2).

Source: Asian Banker Research

Finally, the bank also needs to create an effective organisational business model for resourcing to ensure that skills assessment is performed. This means that the staff should be adequately trained and segregation of duties is clearly defined. According to the same Deloitte survey, most banks believe that three years is the necessary lead time for all phases of IFRS 9.

The Asian response
Banks in Asia have also started working on IFRS 9. In Hong Kong, the regulators, HKMA, have already issued a QIS analysis survey to the local banks to assess the impact of IFRS 9 implementation. While the regulator does encourage its domestic financial institutions to comply with global regulations, deputy chief executive Arthur Yuen did expressed concern earlier this year that “some banks remain unprepared for this deadline of January 2018.”

When speaking with Bank of China HK’s technology officer Tsang Wai Fai responsible for implementing IFRS 9 related projects, he stated that “IFRS 9’s impairment calculations are not the main challenge. It is finding the required historic data to generate accurate calculations”.

Yves Tomballe, regional head of risk and liquidity at BTMU, also expressed similar concerns regarding data. “While the use of accurate forward looking models is essential, what is even more important is to have the right historic data which enables effective stress testing and scenario analysis of portfolios. This requires banks to source the original loan or trade information and connect it to the economic conditions that were prevalent at that time. Gathering such historic data requires time and resources”.

Is IFRS 9 a game changer?
2016 has been a volatile year for financial markets globally. The international political landscape is unstable. From the wars with ISIS in Syria and Iraq, to the refugee crises in Europe to the black swan events such as Brexit and the recent US presidential elections, markets globally have been adversely impacted. With so much uncertainty, many financial institutions have struggled to manage risk exposures effectively and timely.

One main reason why banks have found this volatility challenging is because of the mismatch between their forward-looking risk management models and the backward-looking reporting practices.

Therefore, the introduction of IFRS 9 standards has been long overdue. If successfully implemented, it will force the finance and risk departments at financial institutions, who had historically operated in silos to move towards convergence and start using the same underlying assumptions, practices and calculations to model future events. In the long run, it would hopefully lead to increased transparency for the shareholder who would be able to get a more accurate understanding of the underlying risks of a bank through the financial statements they receive. However before the benefits of IFRS 9 can be realised, the road towards the January 2018 deadline appears to be very bumpy ahead.

Categories:

Basel III, Markets & Exchanges, Operational Risk Management, Regulation, Risk and Regulation, Risk Management, Transaction Banking

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Basel III,Markets & Exchanges,Operational Risk Management,Regulation,Risk and Regulation,Risk Management,Transaction Banking,

Keywords:IFRS 9, Accounting, Risk Management, BTMU, Credit Loss, Basel III, AIG, HKMA