In response to the financial crisis of 2007-2008, the International Accounting Standards Board (IASB) is replacing the “incurred loss” model for loan provisioning (IAS39) with an “expected loss” model for loan provisioning (IFRS 9).
IFRS 9 will come into effect on 1 January 2018. Under the new rule, there will be three separate categories/stages of loans i.e. Origination Risk (1st Stage), Significant Increase in Credit Risk (2nd Stage) and Objective Evidence of Impairment (3rd Stage). Loans will move between these stages depending on changes in credit loss expectations.
A loan would be transferred from first stage to second stage if there is a significant increase in credit risk and to the third stage if there is objective evidence of impairment. However, if there is improvement in the credit risk, the loan may transfer back to stage one from stage two hence reversing the provisions method applied.
Under IFRS 9, Loans in the first stage will be provided for 12-months expected losses and in the second stage, for lifetime losses prior to impairment. Though under IAS39, the same loans that also include ‘impaired but not recognized’ (IBNR) loans (referred to as stage 1 and stage 2 loans under IFRS 9) were provided for incurred losses only. Thus Loans in the first stage and second stage will significantly boost provisioning when IFRS 9 is first applied because the standard requires 12-months ECL and a lifetime ECL before impairment to be deducted for all loans respectively. However, in stage 3 where objective evidence of impairment is available, loans are considered to be impaired under both IFRS 9 and IAS39 so we would not expect any notable impact from the transition to IFRS 9 from these loans.
As implementation of IFRS 9 will significantly increase the provisioning requirement for banks that will in turn reduce the post provision profits in the year of implementation. This will in turn have negative impact on retained earnings that form part of Tier 1 capital. Therefore, in order to maintain the Tier 1 capital ratio as currently prescribed by the PRA, the banks will need more Tier 1 capital. Additionally, regulatory capital ratios will be more volatile depending on the volatility of provisions.
Though there are broad guidelines on how to identify when a ‘significant increase’ in credit risk has occurred, each bank would end up with a different framework depending on the numerous scenarios considered by them. Thus, a loan’s ECL will be calculated differently depending on a bank’s risk assessment of the loan during its life and will vary among banks.
Considering the degree of impact of IFRS 9 on the financial statements, it is essential for the financial institutions to have detailed disclosures around assumptions made for ECL calculations, about the expected credit losses recognized and the impact of changes on credit risk of financial instruments. They should also engage with analysts and the investors to notify them of the changes and to make them aware of how to read the new loan loss provisions for sound interpretation of banks’ financial health and performance.
The implementation of IFRS 9 will be difficult as it requires development of complex models along with data collection at granular level. The key to ensuring compliance is to start preparing at the earliest to implement the required change.
Moreover, there will be significant costs involved related to investment in IT infrastructure and resources along with integration of accounting, IT and risk functions to be able to accurately monitor and report losses complying with the new standard. In turn, this would have an impact on the pricing of certain banking products.
IFRS 9 is being implemented in response to the financial crisis but the magnitude of the losses incurred by many banks during the financial crisis would not have been predicted by any expected loss model as banks incurred huge unexpected losses. The reason is that some banks systematically underestimated risk under the influence of a period of prolonged financial stability and low loan defaults. It is unlikely that banks would have avoided the bail out if they had implemented Expected Credit Loss model governed by IFRS 9 at the beginning of the crisis.
Undoubtedly, IFRS 9 will prepare the banks to weather worsen macro-economic conditions in a much better way but it might not sufficiently prepare the banks to face a financial crisis of the same magnitude as that of 2007-2008.