Right now, most organisations are well on their way to coming up with a compliant solution for IFRS 9. Management are starting to understand the direct impact to their P&L (profit and loss) although thought naturally moves to the other impacts of the implementation of this regulation.
For IFRS 9 there are many direct impacts to consider, both operational and financial. For example, the opportunities for improved pricing or collections strategies, the use of forbearance, the implications of debt sales, the requirements for monitoring, the validation of more sophisticated models and the impact on capital. But there are also many indirect impacts, not least the governance around initial changes and ongoing decisions around parameters and strategies that impact the P&L.
This provides some specific challenges for compliance officers and potentially some significant changes in how they fulfil their role.
Why does IFRS 9 make a difference?
To understand why there are potential changes, we must first understand how these role holders currently fulfil their obligations.
Whilst all organisations are different and all compliance officers approach their roles in different ways, you could say that generally their involvement in the running of the risk function, and its calculation of impairment, covers three areas or stages;
- Consultation or project steering for new requirements, such as changes to the Consumer Credit Sourcebook (CONC) or Disclosure Rules and Transparency Rules sourcebook (DTR), or the changes to the definition of Non-performing Loans issued for consultation by the BCBS (Basel Committee on Banking Supervision)
- Development of policy to support these changes and annual policy reviews and updates
- Thematic or periodic reviews of conduct and controls to maintain compliance
All of these interactions are fairly static, dealing with a steady state or a reasonably lengthy implementation period to create a new steady state.
Whilst this is appropriate for current practice where the relationship between impairment and customer interaction is one way and fairly static, it may not be appropriate in the future where this could become a more dynamic relationship.
The reason for this very one directional relationship is due to the way in which impairment is calculated currently under IAS39. It is currently based on incurred loss, so a binary trigger event has to occur before a loss is recognised in the P&L. These binary events typically occur as a result of financial difficulty and manifest themselves as missed payments (delinquency) or help with payment schedules. Often, once these states are no longer applicable and the customer is back to paying via their regular schedule and are up to date, these assets are treated as performing and only a small amount of provision is held. This has no ongoing impact on the provision of that asset.
Under IFRS 9, these binary measures are only used as backstops, either for entry to Stage 2 or entry to Stage 3 but critically a ‘cure’ period is expected, similar to that used in IRB (Internal Ratings-based Approach) to indicate when an asset has not only got back up to date but is also not likely to re-default in the near future. How this will be assessed is still up for debate but it does extend the period for being treated as Stage 3 (generally aligned to the proposed BCBS definition of Non-performing Loans) even if the account is up to date, for example if interest has been reduced or frozen on a credit card.
In addition to this, IFRS 9 is an Expected Loss approach and places emphasis on monitoring the change in risk of default over the lifetime of the asset. If the change in risk of default is ‘significant’ you are required to move an account to Stage 2 and recognise lifetime losses, this can have a significant impact to your P&L.
Most organisations are using their underlying scorecards as a base to this assessment and most scorecards will factor previous defaults in the overall risk of default; so by applying forbearance, you not only commit to recognising assets in Stage 3 for longer, but also increase the likelihood of remaining in Stage 2 for a period long after they have cured, recognising lifetime losses all through that period.
In this scenario, it could change the way organisations treat early and pre-arrears customers. If they believe that the majority of customers will cure without intervention and that by applying early forbearance they disadvantage themselves by recognising lifetime losses unnecessarily early, they may make a strategy decision to delay contacting those customers.
In the scenario above, under the current practice, this could be something that causes a risk to the bank but the compliance officer would not necessarily be aware of it as this type of decision would typically be made at a local level, by the portfolio risk team, or operations team as it requires dynamic decisions to manage movements in the P&L. The governance process could focus on the financial impact and the resource availability of the operations team and less so on the customer impact.
This may need to change in the future so that compliance officers are more directly involved in dynamic decisions, such as daily, monthly or quarterly changes to contact strategy. More scenario analysis will need to be undertaken to assess impacts to P&L and customers and their interplay, so that decisions can be made more holistically.
This additional involvement, coupled with the important role already undertaken by compliance officers will require additional resource in their teams, supplementary skills, such as more in-depth knowledge of Expected Loss calculations and the PD (Probability of Default), LGD (Loss Given Default) and EAD (Exposure At Default) models that underpin.
This should lead to a broader outlook when responding to new requirements, developing policy statements that support them and conducting reviews to assess overall compliance to them.