R IFRS 9: A Silent Revolution In Banks’ Business Models

expected loss over 12 months. To offset this negativeimpact on their profitability, banks can adjust theircommercial strategies by making changes in pricingor product characteristics: Pricing. When possible, banks shouldcontractually reach agreement with clients ona pricing grid that includes covenants basedon indicators that forecast the probabilityof migration to stage 2, such as the client’sbalance-sheet ratio and liquidity index. Ifa covenant is breached, the rate wouldincrease—for example, by 10 to 20 basis pointsto compensate for the extra cost of stage 2 forexposures between five and ten years, and by25 to 35 basis points for exposures longer thanten years. If flexible pricing is not possible, theexpected additional cost of a stage 2 migrationshould be accounted for up front in pricing. Thiscost should be weighted by the expected timespent in stage 2: for example, 3 to 5 basis pointson average for exposures with a maturity of fiveto ten years, and 5 to 10 basis points for thoselonger than ten years. Product characteristics. Banks couldadjust maturity, repayment schedule, preamortization period, loan-to-value, andbreak clauses to reduce the impact of IFRS 9on their profitability. In particular, theyshould aim to reduce their maturity andamortization profile by providing incentivesto relationship managers and clients to shiftto shorter-term products, and by introducingnew products or options that allow earlyredemption or rescheduling.3. Reforming credit-management practices toprevent exposures from deterioratingUnder IFRS 9, the behavior of each credit facilityafter origination is an important source of P&Lvolatility regardless of whether the exposureeventually becomes nonperforming. Banks therefore4need to enhance performance monitoring acrosstheir portfolio and dramatically increase the scopeof active credit management to prevent creditdeterioration and reduce stage 2 inflows. Differentapproaches can be used to do that, including anearly-warning system or a rating advisory service.Forward-looking early-warning systems allowbanks to intercept positions at risk of migratingto stage 2. This system would extend the scopeof credit monitoring and shift responsibility forit from the credit department to the commercialnetwork. “Significant deterioration” will bemeasured on a facility rather than a counterpartylevel under IFRS 9, so virtually every facility willneed to be monitored to preempt the emergenceof objective signs of deterioration, such as 30 dayspast due. Monitoring facility data and ensuringthat information about guarantees is complete andup to date will be vital in preventing the expensiveconsequences of migrations to stage 2.The commercial network should be fully involvedin a structured process through which riskmanagement flags any facility approachingmigration and identifies the likely reason: forinstance, a deterioration in a debtor’s short-termliquidity or a problem with data quality. Analgorithm—or a credit officer—then assigns possibleremediation and mitigation actions, such as openinga short-term facility to solve a liquidity issue orupdating balance-sheet indicators to improve dataquality. Finally, the relationship manager sees theflagged position and proposed remedial actionson the system and contacts the client to discuss aset of strategies. These might include helping theclient improve its credit rating through business ortechnical measures like those just mentioned, takingsteps to increase the level of guarantees to reducestage 2 provisioning, and adjusting timing andcash flows in the financing mix to the assets beingfinanced so that long-term maturities are usedonly when necessary.

By a rating advisory service, banks could adviseclients on ways to maintain good credit quality,provide solutions to help them obtain better termson new facilities, and reduce their liability to migrateto stage 2. Banks could offer a fee-based serviceusing a rating simulation tool that enables creditofficers and relationship managers to proposehow clients could improve their rating or prevent itfrom worsening. The tool would need to include amacroeconomic outlook and scenarios to forecasthow different economic sectors might evolve; a listof actions for improving or maintaining the client’srating in situations such as a drop in revenues,declining profitability, or liquidity issues; and asimulation engine to assess how ratings may evolveand what the impact of various actions could be.Over time, the bank could build up a libraryof proven strategies applicable to a range ofclient situations.4. Rethinking deal origination to reflect changes inrisk appetiteIFRS 9 will prompt banks to reconsider theirappetite for credit risk and their overall risk appetiteframework (RAF), and to introduce mechanismsto discourage credit origination for clients, sectors,and durations that appear too risky and expensive inlight of the new standard.For example, if banks consider global projectfinance to be subject to volatile cyclical behavior,they may decide to limit new business developmentThe new US standard: CECLBanks active on both sides of the Atlantic face theadditional operational challenge of managing twodifferent standards at once when the CECL modelis introduced in the United States.The current expected credit losses (CECL) modelis part of an update to the United States’ generallyaccepted accounting principles (GAAP) standardon credit losses, introduced by the AmericanFinancial Accounting Standards Board (FASB).Like International Financial Reporting Standard 9(IFRS 9), it marks a move from an incurred-loss toan expected-credit-loss model. Both standardsshare the same objective: correcting the weaknessin previous accounting requirements that led totoo few credit losses being recognized at too late astage during the financial crisis. But there are alsoimportant differences between the two standards:Phasing in. IFRS 9 applies from 2018, CECL from 2020.Measurement of expected credit losses. CECLforesees a single model for calculating lifetime losses;IFRS 9 sets out two models for calculating losses,with a 12-month horizon for stage 1 exposures and alifetime duration for stage 2.Operational and capital implications. The dualmeasurement model introduced by IFRS 9 requiresadditional operational effort from banks to scrutinizeevery asset at every reporting period to determinewhether it might transfer from stage 1 to stage 2 orvice versa. This activity is not required under CECL,because all credit losses are measured over thelifetime of the instrument. This approach could, however,require higher provisioning than under IFRS 9.5

in such deals. To react quickly and effectively to anyissues that arise, they should also adjust the limitsfor project finance in their RAF, review their creditstrategy to ensure that new origination in this area isconfined to subsegments that remain attractive, andcreate a framework for delegated authority to ensurethat their credit decisions are consistent with theiroverall strategy for this asset class.5. Providing new training and incentives topersonnel to strengthen the commercial network1. Implications for portfolio strategies. Should werevise our credit portfolio allocation and lendingpolicies?As banks are forced to provide for fully performingloans that migrate to stage 2, their commercialnetwork will need to take on new responsibilities. Should we reduce lending to volatile sectorswith a poorer outlook? How do we reflect thisin our lending policies?In particular, relationship managers will assume apivotal role, becoming responsible for monitoringloans at risk of deterioration and proposingmitigation actions to prevent stage 2 migration, asnoted above. However, most relationship managershave sales and marketing backgrounds, and thoughthey typically originate loans, they do not activelymanage them thereafter. As a result, they willneed to be trained in new skills such as financialrestructuring, workout, and capital management tohelp them deal with troubled assets effectively. Should we weigh the financial duration ofportfolios more heavily in our lending decisionsand reduce lending on long-term transactions?In addition to introducing training programsto build these capabilities, banks should reviewtheir incentive systems to ensure that relationshipmanagers (RMs) are held accountable for anydeterioration in credit facilities in their portfolio.The RMs should be evaluated and compensated onan appropriate risk-adjusted profitability metric,such as return on risk-weighted assets, return onrisk-adjusted capital, or economic value added,with clear accountability for how well stage2 costs are managed.The strategic and business implications ofIFRS 9: A CEO checklistMost banks have been busy addressing themethodological and technical aspects of IFRS 9—6but only a few have got as far as considering andacting on business implications.1 To anticipate thefar-reaching strategic impact, CEOs, CROs, andheads of business will need to challenge existingIFRS 9 programs with sets of important questionsin each of the five areas we have been discussing. Should we focus on collateralized lendingportfolios to mitigate loss given default andreduce lending to unsecured exposures? Should we treat higher-risk clients differentlyin our lending decisions? Should we scrutinizelending to performing high-risk clients morethoroughly? How should we reflect this in ourrisk appetite?2. Impact on commercial policies. Should werethink our product offering? Should we adjust ourpricing to sustain profitability? Should we adjust maturity and amortizationto shorten product lifetimes? How can weencourage relationship managers and clientsto shift to products with shorter terms or earlyredemption options? Should we raise prices for longer-term andless collateralized products and for higherrisk clients? Would that damage ourcompetitive position?

3. Changes to credit risk management. Should westrengthen our monitoring of counterparty and dataquality to prevent increases in ECL?The introduction of IFRS 9 is likely to changebanks’ behavior and reshape the credit landscapefor some products and segments—but it may alsotempt nonbanks into the market. In particular,banks should keep a watchful eye on the alternativelending sector. Credit provision by private equity,mini-bond issuers, insurance companies, and thelike has grown by more than 20 percent in Europe inthe past five years alone. These new competitors aregoverned by a less stringent regulatory frameworkand could pose a growing threat to banks, especiallyif they are slow to react to the new challenges andcosts of IFRS 9. Should we improve our early-warningmechanisms to detect any deterioration in aclient’s lifetime credit risk? Should we increas

What is IFRS 9? IFRS 9 is an international financial reporting standard published by the International Accounting Standards Board (IASB) in July 2014. It will replace the existing standard, IAS 39, in 2018 and will introduce important changes to accounting rules for financial instruments in three main areas: Classification and measurement. The .