The International Accounting Standards Board (IASB) completed the final element of its comprehensive response to the financial crisis with the publication of IFRS 9 Financial Instruments (IFRS 9) in July 2014. The package introduced by IFRS 9 includes a single, forward-looking ‘expected loss’ impairment model.
The IASB has sought to address a key concern that arose as a result of the financial crisis; that the incurred loss model in IAS 39 Financial Instruments (IAS 39) contributed to the delayed recognition of credit losses.
The IFRS 9 requirement is based on a forward looking expected credit loss model (ECL) and replaces the concept of not recognising a credit loss until a loss event occurs. The need to incorporate forward looking information means that the application of the standard requires considerable judgement as to how changes in macro-economic factors will affect ECLs. The increased level of judgement may also mean that it will be more difficult to compare reported results of different banks. The standard is effective for periods beginning on or after 1 January 2018.
The implications of IFRS 9 are broad ranging, extending beyond the impact on the financial statements. They will require a cross-functional approach , encompassing finance, credit risk, regulatory, capital , data and systems and the impact on the ‘business as usual’ operating model. It is therefore critical that a robust governance framework is put in place as the consequences of design decisions will be felt across financial institutions.
The scope of the impairment requirements is now much broader. Previously, under IAS 39, credit loss allowances were only recorded for exposures where there was a loss event. Now, banks are required to record credit loss allowances for all loan exposures regardless of credit quality. Where there has been a significant deterioration in credit risk since initial recognition, this will trigger lifetime ECLs. For exposures not regarded as significantly deteriorated, this will require a 12 month ECL, meaning that a high quality loan may now attract a greater impairment loss.
The recognition of lifetime ECLs is expected to be earlier and larger than the credit loss allowances required by IAS 39, as lifetime ECLs will be required for all credit exposures that have ‘significantly deteriorated. ‘Significantly deteriorated’ is a new concept in IFRS 9, and is different to ‘impaired’ under IAS 39, leading to a portion of loans that were not impaired under IAS 39 now requiring a provision for lifetime ECLs. For exposures that have not significantly deteriorated, there will also likely be an increase in credit loss provisions as previously the level of credit loss allowances on such exposures depended on the length of the emergence period. Consequently, the overall expectation is that credit loss provisions will increase and result in an equity and regulatory capital impact.
Banks will need to assess how closely to align regulatory requirements with IFRS 9 requirements. Considerations might include:
The availability and quality of data is critical for the successful implementation of IFRS 9. The new ECL approach requires banks to be able to compare credit risk at origination (which may have been a number of years ago) with credit risk at the reporting date and also to factor in future expected credit losses into the loan loss provision. Banks should consider performing a ‘data gap analysis’ at an early stage to identify areas where there may be issues with data availability and/or data quality.
Management will also need to consider how these changes will impact business as usual once IFRS 9 is adopted. Given the requirement to hold lifetime ECLs when an asset has decreased in credit quality, but before an asset might be considered impaired, there are considerations in relation to product pricing, risk appetite, capital planning and stress testing.
It is critical that finance and credit risk management systems and processes are connected due to the necessary alignment between risk and accounting. Risk models and data will have to be more extensively used to make the assessments and calculations required for accounting purposes. It is likely that systems and processes will be based on those used for credit risk management, and so application of the standard will require a much closer alignment of credit risk management and financial reporting functions than may currently be the case. Banks will, where feasible, seek to make use of existing credit risk management and regulatory reporting systems. But most banks will need, at least in part, to build new systems and processes in order to implement the standard.
Many banks will run the new processes in parallel with the old over the course of 2017. This will also enable them to communicate the effect of transition to stakeholders, such as shareholders and regulators, in advance of the effective date. In addition, banks will need to fully understand the complex interactions between the IFRS 9 and regulatory capital requirements. In many cases, it is expected that the new IFRS 9 expected credit loss requirements will result in a reduction in the regulatory capital of banks.
Banks should not underestimate the degree of required change to existing processes. The interaction of many competing requirements requires a well thought out IFRS 9 design and implementation plan, and banks can expect many challenges between now and the date of full implementation.