IFRS 9: A New Model For Expected Loss Provisions For .
IFRS 9: A new model for expected loss provisionsfor credit riskIFRS 9 Financial Instruments, the international financial reporting standard, substantiallymodifies existing procedures for expected loss provisions related to assets’ credit risk. Thenew accounting standard changes the current provisioning model, based on the recognition ofactual, materialised losses (generally loans past due by 90 days), to one based on expectedlosses at the time loans are granted. The new approach requires banks to create or adapt theirmodels and methodologies for estimating expected credit losses on their various portfolios.Moreover, estimations will need to factor in the requirement that expected loss provisionsbe conditional upon the foreseeable outlook for the economy and consider the residuallives of the various transactions. While the Basel Committee on Banking Supervision iscurrently assessing various arrangements to smooth IFRS 9 implementation, the initial impactstudy carried out by the EBA points to significant increases in provisioning requirements anddecreases in CET1 ratios at financial institutions.The chief role played by the banks in the economyis to channel savings from households andcompanies which hold surplus funds (savingssurplus units) to households and companies whichneed funds for spending or investment purposes(savings deficit units). This intermediation role iscrucial as the interests of the various surplus anddeficit units do not necessarily coincide in terms ofthe maturities and rates at which funds are offeredand solicited. It is up to the financial institutionsto overcome this mismatch and to channel funds1A.F.I. - Analistas Financieros Internacionales, S.A.efficiently by accepting deposits (generally shortterm and usually at fixed rates) and making loansto finance consumption or investment (usuallymedium‒ and long-term loans at rates whichtypically involve a higher degree of variability). Asa result of this intermediation, a series of financialrisks inevitably arise.Due to differing interest rates and terms ofmaturity between funds received and thoseloaned, the banks assume two kinds of risks75SEFO - Spanish Economic and Financial OutlookThe entry into force of IFRS 9 next year marks a fundamental change in theprovisioning paradigm for financial institutions, moving away from the actual,incurred credit loss model to an expected loss approach. The upcomingchanges are anticipated to have material implications as regards increasing banks’provisioning requirements, as well as decreasing their common equity tier one(CET 1) ratios.Vol. 6, N.º 1 (January 2017)Pilar Barrios and Paula Papp1
Pilar Barrios and Paula PappVol. 6, N.º 1 (January 2017)known as ‘structural balance sheet risks’: interestrate risk and liquidity risk. Although these risks areSEFO - Spanish Economic and Financial Outlook76When channelling savings from householdsand companies with surplus funds to thosein need of resources, banks assume a rangeof risks, specifically including credit risk orthe risk of non-performance.significant and require due management, thebiggest source of risk generated by this businessis another: that related to the credit risk, namelythe risk of non-payment or non-performance.To safeguard the solvency of banks, which playa vitally-important role in the economy, thereare a series of requirements related to capitaland provision buffers which they must hold asa function of the risks they assume. To this end, adistinction is generally made between expectedand unexpected losses. The Basel capitalrequirements have arisen in response to thelatter concept. The purpose of the capital banksare required to hold is to cover their unexpectedlosses; the amount of this capital must besufficiently high so that the entity will be able totackle loss scenarios for which the probability ofoccurrence is very low but which, if they were tooccur, would have a significant impact.Accordingly, the logic behind the capitalrequirements is to cover unforeseen losses bymeans of capital buffers; foreseen losses,materialisation of which is considered highlyprobable, should be contemplated in profit andloss.This highly reasonable logic is not, however,aligned with existing regulatory requirements.The capital requirements applicable to financialinstitutions are enshrined in the well-known Baselregulatory framework which has indeed beencalibrated in an attempt to cover (with varyingdegrees of success) unexpected losses. Lesswell-known are the regulations which apply toimpairment provisioning requirements. In Spain,the current provisioning regime is that stipulatedin Appendix IX of Bank of Spain Circular 4/2004Exhibit 1The role played by the banks in the economySavingssurplusunits They place their surplus funds Short-term At predominantly fixed ratesThe banks as intermediaries Assume risks Credit risk Interest rate risk Liquidity risk Earn profitsBanksSavingsdeficitunitsSource: AFI. They apply for funds to financeinvestments expenditure Long-term Higher component of ratevariability
IFRS 9: A new model for expected loss provisions for credit riskThis logic will change from January 1st, 2018,when International Financial Reporting StandardOverview of IFRS 9Development of IFRS 9 rounded out theInternational Accounting Standards Board’sresponse to the financial crisis of recent years.Upon entry into force of IFRS 9 fromJanuary 1st, 2018, the logic underpinningcredit impairments will shift from an incurredloss model to an expected loss approach.77As already noted, it is scheduled to enter into effecton January 1st 2018, as stipulated in CommissionRegulation (EU) No. 2016/2067, published inExhibit 2Contents of IFRS 9Classificationof assetsand liabilitiesAsset classificationaccording to level ofimpairment Assessment, at thereporting date, ofwhether credit riskhas increasedsignificantlycompared to the dateof grant or initialrecognitionSource: AFI.Vol. 6, N.º 1 (January 2017)The amendments recently made to Appendix IX,which took effect on October 1 st, sought toalign the Bank of Spain’s requirements with theinternational accounting standard currently inforce, namely IAS 39. This international accountingstandard primarily follows an incurred loss model.This means that the banks have to recogniselosses on loans extended essentially when theyare realised, i.e., when the counterparty hasalready stopped complying with his obligationssuch that the loan is in default (understood as aloan in arrears by 90 days) or showing signs ofsignificant impairment, i.e. an indication that thecounterparty will not be able to repay 100% of hisdebt (‘doubtful for reasons other than borrowerarrears’).(IFRS) 9 enters into force. The focus of IFRS 9 isto shift the model underpinning IAS 39 towards onein which entities have to provision for expectedcredit losses at the time of granting and thenassess impairment with respect to expectationsat the time of initial recognition.Determinationof provisioningrequirementsHedge accoun tingCalculation ofexpected creditlosses Lifetime if there isevidence ofsignificantimpairment of creditrisk 12 months if notSEFO - Spanish Economic and Financial Outlook(as recently amended by Circular 4/2016). Theserules establish the criteria for classifying an assetas ‘doubtful’ (on account of borrower arrears or forother reasons) and the amounts to be set asidedepending on the associated risk levels.
Pilar Barrios and Paula PappVol. 6, N.º 1 (January 2017)the Official Journal of the European Union onNovember 22 nd, 2016. This new accountingstandard does not apply exclusively to financialinstitutions but to all manner of companies. Onlyinsurance companies, as stated in the Regulation,are allowed to defer its implementation.SEFO - Spanish Economic and Financial Outlook78Chapter 1 of IFRS 9 stipulates that its objective “isto establish principles for the financial reporting offinancial assets and financial liabilities.” Therefore,the standard is broader in scope than determinationof provisioning requirements, although this isthe area of the new standard expected to have thegreatest impact on banks when they apply it forthe first time next year. In addition to prescribinghow to determine provisioning requirements, thestandard also amends the former financial assetand liability classification and hedge accountingregimes.Although the standard is broader in scope, itis worth noting that this article addresses thetreatment of credit impairment for accountingpurposes, as the other two areas of change, whileimplying modifications with respect to the currenttreatments, are not expected to have as significantan impact as the new provisioning model.In order to delve further into the new accountingstandard, the treatment of impairment provisionsis broken down into two key aspects: theclassification of assets by level of impairment andthe calculation of expected loss.Asset segmentation under IFRS 9On the first matter, IFRS 9 prescribes classifyingassets as a function of an assessment, at thereporting date, of a given transaction’s credit riskin comparison with the risk of a default occurringat initial recognition.This approach is underpinned by transactionpricing theory. When a loan is granted, by setting therate of interest to be charged on the transaction,the banks have to analyse the various “factors ofproduction” used in order to extend it: the fundingcost (internal and external), the general expensesIFRS 9 segments assets into three stagesdepending on whether they are performing,have experienced a significant increase incredit risk or are already impaired or nonperforming.they must incur to originate and maintain theposition and the expected cost of credit risk,i.e., expected loss. As a result, transactionswith different probabilities of default should beassociated with different interest rates so that thehigher the risk, the higher the rate of interest orspread charged.When testing an asset for impairment, if itpresents the same level of credit risk as it didwhen it was initially measured, albeit factoringin the transaction’s normal development over time,the interest rate established should continue tocover the corresponding expected credit losses.Therefore, just as entities will recognise the interestincome received in profit and loss, the new standardstipulates the need to cover the associatedexpected losses from when the transaction isinitially recognised.If, in contrast, the transaction has sustained asignificant increase in credit risk with respect tothe granting or initial recognition date, the interestrate applied is no longer deemed sufficient tocover the potential risk and higher provisioningrequirements are deemed necessary.Following this pattern of deterioration in theobserved credit risk of financial instruments,the standard categorises transactions into threegroups: Stage 1, Stage 2 and Stage 3.Stage 1 assets are those whose credit risk hasnot increased since initial recognition such that
IFRS 9: A new model for expected loss provisions for credit riskTable 1Segmentation - IFRS 9 StagesSTAGE 2RebuttablepresumptionLoss recognitionOpening balanceInterest incomeCredit risk does not increase withrespect to that initially recognisedCredit risk increases significantly;credit quality ceases to be“investment grade”Payment past due by 30 daysThe deterioration in credit quality hasled to the materialisation of creditlossesPayment past due by 90 days Amortised cost using the initialeffective interest rate adjusted in aseparate account for 12-month ECLs Lifetime expected credit losses(over the entire remaining lifeof the instrument) in respect ofnon-payment or late payment Usually assessed collectively forlike types of contractsAmortised cost using the initialeffective interest rate adjusted in aseparate account for lifetime ECLsEffective interest rate on grossopening amortised cost, not adjustedfor credit lossesEffective interest rate on grossopening amortised cost, not adjustedfor credit lossesRecovery of the loss is implicit in theinitial effective interest rate 12-month expected creditlosses (total ECLs times theprobability of occurrence withinthat timeframe)STANDARD EXPOSURESCORRESPONDENCETO BANK OF SPAINCIRCULAR 4/2006(Approximation)(performing)All expected credit lossesUsually assessed individuallycontract by contractNew balance: Amortised cost usingthe initial effective interest rate lesslifetime ECLsEffective interest rate on net openingamortised cost, i.e. gross amortisedcost after deducting the impairmentallowance STANDARD EXPOSURES UNDER DOUBTFUL EXPOSURES ONACCOUNT OF BORROWERSPECIAL MONITORINGARREARS DOUBTFUL EXPOSURES FORREASONS OTHER THANBORROWER ARREARS(non-performing)(underperforming)Source: AFI.the interest rate established for the transaction inquestion embodies a reasonable estimate of theassociated expected loss. The equivalent to thissegment in current Bank of Spain nomenclature(as per the official translation) is that of aperforming or ‘standard’ exposure.Stage 2 assets are those for which credit risk hasincreased significantly since initial recognition,albeit without a credit event occurring. To assesswhether such an increase has taken place,IFRS 9 provides operational simplifications suchas a 30 days past due rebuttable presumption.Although not directly equivalent, this ‘bucket’ isroughly similar to exposures currently deemed‘standard under special monitoring’ and ‘doubtfulfor reasons other than borrower arrears’. In sum,assets whose recovery is subject to question butwhich cannot yet be classified as non-performingor doubtful.Lastly, Stage 3 includes transactions for whichlosses have already been incurred. Accordingly,this bucket can be considered similar to assetscurrently classified as ‘doubtful on account ofborrower arrears’.Determining impairment provisions(expected loss) under IFRS 9As already noted, IFRS 9 changes the provisioningtreatment paradigm, moving away from anincurred loss model to an expected loss approach.This means that the banks will stop recognisingthe bulk of their credit risk losses at default (pastVol. 6, N.º 1 (January 2017)DescriptionSTAGE 379SEFO - Spanish Economic and Financial OutlookSTAGE 1
Pilar Barrios and Paula PappExhibit 3Segments and applicable provisionsVol. 6, N.º 1 (January 2017)CreditqualityPerforming/standard(Stage 1)Payments arecurrent and there isno evidence of anincrease in credit risksince initial recognitionSignificant increase incredit risk(Stage 2)Exposur es exhibitingclear-cut impairmentin their credit riskcompared to initialrecognition12-month expectedcredit lossesNon-performing(Stage 3)Exposur esclassified as nonperforming (default/ unlikeliness to pay/ pulling effect)Lifetime expected credit lossesSource: AFI.SEFO - Spanish Economic and Financial Outlook80due by 90 days) and start to recognise a bufferto cover potential losses upon initial recognition.This makes sense insofar as the risk really existsfrom when the transaction is arranged and not fromwhen non-performance begins.Given that an asset’s expected loss is subject tochange if macroeconomic conditions vary, IFRS 9Under IFRS 9, provisions are allocatedas a function of asset stages. For Stage 1assets, reporters are required to analyse andprovision for expected credit losses in 12months’ time, while for Stage 2 and 3 assets,the provision calculation must reflect thecredit losses expected to be incurred over theirentire lifetime.requires the use of economic forecasts for themodelling time horizon so long as the associatedcost or effort is not disproportionate.2The general criterion is that for Stage 1transactions, impairment provisions should cover12-month expected credit losses (ECLs), while forasset classified as Stage 2 or Stage 3 exposures,the provisions should cover lifetime expectedcredit losses.Potential impact of IFRS 9 applicationGiven that this is such a fundamental changein how the various assets and liabilities areaccounted for, the European Banking Authority(EBA) has analysed the potential impacts of itsapplication.2 The EBA has determined that theaspects of IFRS related to the classification andmeasurement of assets and liabilities did notparticularly concern the banks, as application ofthe new criteria is not expected to have a majorimpact on their financial statements. In contrast,implementation of provisioning calculationsbased on an expected loss model, particularlythe use of lifetime ECLs for Stage 2 assets, isexpected to translate into a significant increasein total impairment provisions. Specifically, pact-on-banks-across-the-eu
regulatory treatment of accounting provisions.In the event that the new ECL provisioningrequirements have a high impact on the banks (tobe determined on the basis of studies currentlyunderway), this document paves the way for atransitional arrangement for the new accountingrules on regulatory capital. To this end, threepossible approaches to how a transitionalarrangement might be structured (over a three- tofive-year period) are under consideration:Qualitatively, the aspect of greatest concerngleaned from the EBA’s study was the factthat a large number of entities were at an earlystage of preparation for the new standard. Morespecifically, the smaller banks were lagging furtherbehind, despite the likelihood that these entitiesneed to make the greatest efforts to adapt to theextent they do not already have internal ratingsbased (IRB) models to leverage for the purposeof developing expected loss models to calculatetheir provisioning requirements. Approach 1 - Day 1 impact on CET1: Thefirst approach consists of evaluating the impactof the new accounting regulations on an entity’sCET1 in absolute terms and spreading thatimpact for regulatory purposes over the numberof years specified by the Committee. Approach 2 - Impact in relative terms: The secondapproach consists of evaluating the capitaladjustment linked to the proportionate increasein provisions and spreading that impact usingthis percentage of provisions figure.Meanwhile, on October 11 th, 2016, the BaselCommittee on Banking Supervision (BCBS) 3released a consultative document to assess, froma policy standpoint, the potential interim approachand transitional arrangements in respect of the Approach 3 - Phased recognition of Stage 1and 2 provisions: The third approach wouldExhibit 4BCBS approaches towards the impact on regulatory capitalApproach 1Approach 3CET1 ECLCET1 ECL.CET1 UL*Approach 2Spreadout on astraightlinebasisStage 1.XProv tPhasedrecognitionStage 2CET1 UL*Stage 3SpecificconsiderationsNote: * UL Unexpected Loss.Source: Regulatory treatment of accounting provisions – discussion document, Basel Committee on BankingSupervision (BCBS), October 11th, 2016.3https://www.bis.org/bcbs/publ/d385.htm81SEFO - Spanish Economic and Financial Outlookprovision volumes are expected to increase by18% on average (and by up to 30% for 86% ofthe respondents), while common equity tier 1(CET1) ratios are expected to decrease by 59basis points on average (and by up to 75bp for79% of the respondents). Another relevant aspectdetected by the EBA is the significant expectedincrease in income statement volatility.Vol. 6, N.º 1 (January 2017)IFRS 9: A new model for expected loss provisions for credit risk
Pilar Barrios and Paula Pappdirectly phase in recognition of the provisioningrequirements in respect of Stage 1 and Stage 2assets for regulatory purposes over thetransition period.Vol. 6, N.º 1 (January 2017)Challenges ahead for IFRS 9implementationSEFO - Spanish Economic and Financial Outlook82The work to be performed to adapt provisioncalculations for the new international accountingstandard should not be underestimated. Inparticular, one of the most novel aspects, and theone which implies the greatest burden of work, lieswith the requirement to use internal models andestimates to calculate provisioning
(IFRS) 9 enters into force. The focus of IFRS 9 is to shift the model underpinning IAS 39 towards one in which entities have to provision for expected credit losses at the time of granting and then assess impairment with respect to expectations at the time of initial recognition. Overview of IFRS 9 Development of IFRS 9 rounded out the
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