On January 1, 2018, the accounting methodology for credit impairment will be dramatically overhauled, requiring European financial institutions to move from an incurred credit loss (past) to an expected credit loss (future) model. That date, of course, is the implementation deadline for the IASB’s International Financial Reporting Standard 9 (IFRS 9)
IFRS 9 and its US counterpart, CECL, will bring major changes to financial statements, presenting challenges and ratcheting up uncertainty in the process. Banks and investors will see major differences in reported numbers (particularly when compared with historical financial reports), and 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 not only significantly increases the volatility of earnings but could also force the reduction of balance sheets; the freeze or disposal of certain businesses; and a need for banks to boost their capital influx (to stay above regularity minimums). Under the standard, credit loss projection volatility is expected to exceed both historical derived norms and calculations required by Basel 3 for credit risk.
What’s more, financial institutions’ will have to transition from a loan loss provisioning model that is based on existing default events (the current model) to one that accounts for losses over the lifetime of a loan. The provisioning will move from a framework that relies on 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.
More specifically, IFRS 9 follows a dual credit-loss measurement approach in which expected credit losses (ECLs) are measured in stages to reflect deterioration over different periods, ranging from a 12-month loss to a life-of-loan loss.
IFRS 9 has three types of loan stages: (1) stage 1 loans must recognize expected ECLs over a 12-month period; (2) stage 2 loans must measure lifetime ECLs; and (3) stage 3 loans must calculate lifetime ECLs plus a haircut to future interest revenues. Banks, moreover, 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.
Loss estimates under IFRS 9 must be recalculated at quarterly intervals to reflect new information about credit and economic conditions that come to light during each reporting period; this will require a determination to be made about whether probability of default (PD) for each specific loan has increased since the initial loan recognition. If PD has increased, capital may need to be reallocated.
The new financial accounting standards are principle-based, are not prescriptive and do not recommend any single approach. Furthermore, the Financial Accounting Standards Board (FASB) will allow institutions to adopt approaches based on their complexity and size, leaving lots of room for interpretation.
Compounding this problem is the fact that both CECL and IFRS 9 require firms to forecast the predictable future. Since loss provisions reflect the future, different macro scenarios need to be applied – including some that could have a negative impact. For example, a sudden, sustained economic downturn that affects multiple sectors and that occurs between reporting dates could force an en bloc downgrade of loans, resulting in a steep rise in provisioning that could eventually lead to capital shocks.
The challenges involve significant and far-reaching decision making, revolving around (a) initial impact and gap assessment; (b) interpretation of the standard; (c) ownership of the program; (d) stakeholder contributions and integration; (e) retooling and repurposing of credit models; (f) asset classifications and categorization; (g) data collection; and (h) inventory requirements for stress testing and scenario development.
All of these challenges should be addressed in a consistent, prudent fashion via a policies and procedures document that should clearly explain the organization’s definition of default. It should furthermore provide an interpretation of what the organization considers a “significant deterioration of credit risk” while outlining the assumptions it makes about ECL models, qualitative factor adjustments and macroeconomic overlays.
Essential elements in the policies and procedures document should also include the firm’s governance, framework, objectives, principals, controls, methodology, strategy and allowable permitted mitigants to address earnings volatility. Most importantly, it should depict the firm’s reporting and communication plan for auditors, investors and regulatory bodies.
Given the significant part played by technology and systems, a technology framework document is also a must. This should be regularly updated with respect to adaptions and interpretation of rules changes, and it should demonstrate how the integrated loan loss provisioning platform will support a variety of runs on a month-end basis. Moreover, it should explain in detail how the loan loss provisioning platform is integrated with the firm’s accounting software.
In December 2015, the Basel Committee on Banking Supervision (BCBS) published its guidance on credit risk and accounting for expected credit losses. It highlighted 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 that lifetime ECLs should be anticipated and recognized before a missed payment occurs. In its guidelines, moreover, the BCBS states 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. It’s important to follow these guidelines, since regulators across multiple geographies will likely expect alignment of credit risk assessment across products, business units and jurisdictions.
Modeling of lifetime expected losses will likely be at the forefront of IFRS 9 implementation efforts, along with issues pertaining to data quality, availability and collection. Implementation cannot be seen as a one-off effort; the systems, data and reporting mechanisms must be both scalable and repeatable.
Banks can suppress loan-loss volatility by establishing a loan allocation strategy prior to the implementation of the regime – e.g., through a plan for how their assets will be sorted into their respective buckets, and how they will 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.
A well organized and integrated organization has the following characteristics: (1) time series availability for PD and for loss-given default (LGD) modelling; (2) a demonstrated capability of building sophisticated, validated and properly documented models; (3) established procedures for monitoring model performance; (4) established default definitions; and (5) model governance that meets the minimal standards of the European Banking Authority (EBA).
These competencies will allow an organization to have a better ability to repurpose existing credit risk capital models to provide the point-in-time estimates required under IFRS 9.
The introduction of IFRS 9 is a sea change for credit impairment. The lessons learned through IFRS 9 deployment should offer valuable guidance to organizations that need to implement CECL in the US.