International Financial Reporting Standard 9 (IFRS 9) is a new accounting standard set to replace International Accounting Standard 39 (IAS 39). It introduces a new approach to accounting for financial instruments and is expected to become effective in December 2018. The three main areas covered by IFRS 9 are:
- Classification and measurement of financial instruments
- Impairment of financial assets
- Hedge accounting
This paper focuses on the impairment of financial assets aspect of the new standard. The impairment assessment depends on the expected credit losses of the financial instrument and affects the nature of the impairment allowance as well as the way accrued interest is evaluated.
Below, we evaluate the implications of the new standard for credit models, with thought given to how this relates to existing Basel II internal ratings-based (IRB) models or models for stress-testing purposes.
Expected Credit Loss
There are three stages to consider when determining how to measure expected credit loss (ECL). Initially, the ECL is determined over a 12-month period from commencement of the exposure. This is the estimated credit loss arising from the expected default events over the initial 12 months. What happens next is determined by the evolution of the credit quality. Table 1 defines the three stages of credit quality and their implications for the ECL:
Please note the following:
- Stage 2 reflects the assessed change in risk since initiation of the exposure, rather than the absolute level of risk.
- Assets may transition back to Stage 1 if the credit risk reverts back to what it was at the outset.
- To evaluate the ECL to the maturity of the exposure (lifetime ECL), assess the ECL for each of the years to maturity, then calculate the present value over the entire range.
- The asset quality is continuously assessed while the credit losses are aggregated at each of the institution’s internal or regulatory reporting dates.
Implications for Risk Models
Basel II has similar terminology to IFRS 9, i.e., probability of default (PD), loss given default (LGD), and exposure at default (EAD), but the precise definitions, timescales and calibrations of these measures differ between Basel II and IFRS 9. For Basel, these credit parameters ultimately lead to an assessment of unexpected loss and hence, regulatory capital. The treatment of corporate and retail exposures also varies. For IFRS 9, the parameters lead to expected loss.
Some of the differences are highlighted in Table 2 below:
It is clear that, although the approaches are related, IFRS 9 differs from Basel II in many areas. Much of IFRS 9 can be derived from the relevant point-in-time measures for the current and each future year, which are then combined via transition matrices between years. All of the potential migration paths need to be considered when assessing the probability of a loan reaching a given credit state.
In addition, the business’s assessment of the economic cycle should be factored into the assessment of the credit parameters for each year. The problem therefore becomes more complex and requires an evaluation of PD, LGD and EAD based on past experience at given points in the economic cycle. Here, the experience of the institution in performing scenario analyses and stress tests should be pertinent.
One may conclude that institutions that have already accumulated data and experience for Basel II and stress testing are better placed to extend their analyses to IFRS 9. However, the different nature of those analyses will require the historical data to be stored and extracted in a manner appropriate for the purpose, with implications for data warehouses and IT systems, as well as the resulting analyses and calibrations.
Where an institution has little Basel II or stress-testing experience, a more qualitative approach may be required. This involves the use of average values, leveraging the available data (from both internal and external sources) and applying credit analyst judgement.
The key consideration is to ensure that the approach taken is defendable and can be shown to be reasonable, given the circumstances.
Protiviti’s Point of View
IFRS 9 presents new challenges to financial institutions already struggling with many other interacting regulatory and operational requirements. However, it also addresses long-standing issues with the traditional approaches to calculating credit loss, which typically consider only one year, or the cycle average over one year. IFRS 9 requires the institution to consider, where pertinent, the evolution of credit quality to maturity, which, from a risk management perspective, is a more transparent approach. This approach should, in addition to satisfying the regulators, lead to better credit approval decisions, which also will improve over time as the supporting data accumulates.
The updated accounting standard will impact the entire financial services industry, from banks with global exposures to community banks and specialist lenders. In addition, the new standard will impact multiple internal functions and business lines, requiring collaborative efforts across the organisation to meet its requirements.
It is expected that the industry will have until 2018 to implement the updates. This should give organisations enough time to prepare for the implementation – but they must begin these preparations now to meet the expected timeline.
The first step that an organisation should take is to perform a gap assessment to identify the areas that require improvement. After the gap assessment, the organisation can devise an implementation plan and identify the required changes and resourcing. A thorough gap assessment allows the implementation tasks to be prioritised, avoiding duplication of effort across other internal projects.
For example, some organisations have previously implemented Basel II and/or stress-testing programs, and their models, data, systems and processes may be leveraged for IFRS 9 implementation. However, organisations with smaller asset sizes may find that more of their asset portfolio requires enhancement; hence, a more significant effort would be required to fulfil IFRS 9. Much of the modelling for these smaller banks will need to be custom-built, reconfigured and recalibrated for IFRS 9.
How Protiviti Helps Companies Meet IFRS 9
Most institutions’ credit models will require amendment or possible rebuilding in order to comply with IFRS 9. Protiviti helps institutions identify the key areas for IFRS 9 improvement. We leverage our expertise and experience with allowance and credit risk model design, process design, system implementation and model validation to design and build customised solutions for our clients.
The requirement of forward-looking and lifetime loss forecasts has become one of the key concerns to implement IFRS 9 methodology. We deploy our model risk experts to assess clients’ models and provide the recommendations to calibrate or redesign the model. Our model risk team also performs independent third-party model validation to assess compliance with IFRS 9 requirements and industry standards, prior to or after the implementation.
Protiviti’s global resources can assist with international exposures and implementing and validating the client’s program under the requirements of both IFRS and the Federal Accounting Standards Board’s updated impairment accounting standards in the United States.