Implementation of International Financial Reporting Standard 9 (IFRS9) on January 1, 2018 will overhaul the accounting methodology of credit impairment with dramatic results, moving from an incurred credit loss (past) to an expected credit loss(future). IFRS9 and its US counterpart CECL impacts are so public and material to the financial statements that the transition brings a lot of uncertainty and challenges. Banks and investors will see major differences in reported numbers compared with historical financial reports and they will collectively need to rationalize the extent to which these differences are due to accounting rule changes versus something more fundamental to the portfolio.
IFRS 9 significantly increases the volatility of earnings and could force the reduction of balance sheets, the freeze or disposal of certain businesses and the scramble to replace capital to stay above regularity minimums. Credit loss projection volatility is expected to exceed both historical derived norms and calculations required by Basel 3 for credit risk due in large part to stage transferring criteria, scenario choice, methodology and the effective life of an instrument.
The loan loss provisioning model transitions from one based on an existing default event to a Day 1 Life of loan loss; meaning that that your loss is realized much earlier than before. The provisioning moves from a framework that relates common metrics – such as days past due and other likely default indicators – to one where the lifetime loss estimates can vary based on multiple, less transparent factors. IFRS 9 follows a dual credit-loss measurement approach in which expected credit losses are measured in stages to reflect deterioration over a period, moving from a 12 month to a life of loan loss.
IFRS9 has three types of loan stages, Stage 1 loans must recognize expected credit losses ("ECLs") over 12 months, stage 2 lifetime ECLs, and stage 3 lifetime ECLs plus a haircut to future interest revenues. Banks must draw these provisions from the same pool of retained earnings used to buttress Common Equity Tier 1 capital, meaning a spike in ECLs will result in an equal plunge in capital ratios. IFRS9 loss estimates must be recalculated at quarterly intervals to reflect new information about credit and economic conditions that come to light during each reporting period, with a determination made, on the three types of loan stages, as to whether their PD (potential default) has increased, since initial recognition and whether there needs to be a reallocation.
What are the challenges?
The Financial Accounting Standards are principle based, are not prescriptive and do not recommend any single approach. Furthermore, the Financial Accounting Standards Board allows institutions to adopt approaches based on their complexity and size, therefore leading to much interpretation. To compound this interpretation, is the need to forecast the predictable future and since loss provisions reflect the future, different macro scenarios need to be applied. These macro scenarios can cause certain challenges for instance, a sudden sustained economic downturn affecting multiple sectors occurring between reporting dates, may force the down grade of loans by a stage en bloc, with the attendant steep rise in provisioning potentially leading to capital shocks.
The challenges are multiple and involve significant and far reaching decision making, ranging from a) initial impact and gap assessment, b) interpretation of the standard) ownership of the program, d) stakeholder contributions and integration, e) retooling and re-purposing of credit models, f) asset classifications and categorization, g) data collection and h) inventory requirements to stress testing and scenario development. All these challenges should be addressed in a consistent, prudent fashion embedded in a Policies and Procedures document. This document should furthermore state the organization’s definition of default, low credit risk and interpretation of significant deterioration whilst outlining the assumptions made of ECL models, qualitative factor adjustments and macroeconomic overlays. Essential elements in the document will also include the governance, framework, objectives, principals, controls, methodology, strategy and allowable permitted mitigants to address the volatility in earning.
Other components woven in to the document should show the inner operational workings, the alignment of budgeting, training and education, coordination with capital planning, balance sheet projections and influences on product design and pricing. The most important section of the Policies and Procedures is the reporting and communication plan to the auditors, investors and regulatory bodies.
Given the significant part played by technology and systems, a technology framework document is a must, regularly updated in respect of adaptions and interpretation of rules changes. The framework document will show how the integrated loan loss provisioning platform will need to support a variety of runs on a month-end basis, with all the requisite approvals and documented explanations as to why the allowance moved the way it did in a limited time frame. Moreover, the framework document will explain in detail how the platform is integrated with the accounting software.
The Basel Committee on Banking Supervision (BCBS) published guidance in December 2015 on credit risk and accounting for expected credit losses. It highlights three IFRS -specific requirements banks should consider when designing and operationalizing their implementation plan. With respect to defining and measuring significant deterioration in credit risk, the BCBS is of the view that delinquency data should only be used in rare circumstances and lifetime expected credit losses are generally anticipated to be recognized before a missed payment occurs. BCBS guidance provides that banks should “have processes in place that enable them to determine [significant credit risk] on a timely and holistic basis so that an individual exposure, or a group of exposures with similar credit risk characteristics, is transferred to [lifetime expected credit losses] measurement as soon as credit risk has increased significantly, in accordance with the IFRS 9 impairment accounting requirements. The BCBS guidance also recommends that banks establish policies and specific criteria for what constitutes a “significant” increase in credit risk for different types of lending exposures. Regulators across multiple geographies will likely expect alignment of credit risk assessment across products, business units, and jurisdictions.
Model lifetime expected losses, issues around data quality, availability and collection will likely be at the forefront of implementation efforts. This is not a one-off effort, the systems, data and reporting mechanisms will have to be both scalable and repeatable.
Banks can suppress loan-loss volatility by establishing a loan allocation strategy prior to the implementation of the regime – a plan for how their assets will be sorted into their respective buckets, and move between them, by the go-live date. One strategy would be to consider pre-emptively downgrading loan books that are most at risk of a rise in PD by shifting them into the next bucket down, effectively front-loading any resultant capital hit and helping smooth profit and loss volatility.
Of course, the best mitigants are planning and preparation, with a design program implemented involving parallel runs, giving the organization a better chance of understanding and ironing out the issues generated. A well organized and integrated organization would possess the following characteristics and capabilities a) time series available for PD and Loss Given Default (LGD) modelling; b) demonstrated capability of building sophisticated, validated and properly documented models; c) procedures in place to monitor model performance; d) default definitions in place and e) model governance meeting the minimal standards of the European Banking Authority (EBA). These competencies will allow the organization to have a better ability to re purpose existing credit risk capital models to provide the point-in-time estimates required under IFRS9.
The introduction of IFRS9 is a sea change for credit impairment. The lessons learnt by implementation and education should offer a footprint for organizations that should address CECL in the US. #risksmartinc