A regulatory cost or a business opportunity?
The financial services industry is currently busying itself with building models to predict the lifetime losses under the new IFRS 9 accounting standard, specifically for their stage 2 and stage 3 accounts. Generally, these are account level lifetime loss predictions with the ability to mechanically adjust to use probability weighted economic scenarios. This is being done either through re-deployment of existing resources, hiring of new resources, contractors or external consultancies. This is all been done with one sole aim – to ensure the impairment allowance contained in the company accounts is compliant with the IASB standard and therefore satisfy auditors.
However, let’s look again at what is being built:
“…account level lifetime loss predictions with the ability to mechanically adjust to use probability weighted economic scenarios.”
In our experience, this kind of predictive modelling is a significant enhancement on anything most organisations currently possess. It therefore makes sense to use it to drive better credit decisions and increase bottom line profits and returns through a range of uses, including:
• Optimising the use of liquidity/funding & capital
• Identifying growth and withdraw segments
• Recognising concentration risk
• Setting risk appetite
The first two concepts are achieved through an enhanced credit approval processes.
Credit decision-making through scoring has long been the standard within the industry, however the use of these scores varies across organisations. We generally see three broad categories of increasing sophistication:
• Cut-offs set on a perceived level of acceptable risk e.g. we want default rates less than X %
• Cut-offs set on simple break even modelling based on average loss and income expectations
• Cut-offs set using fully modelled expectations of returns by targeted segments (against a range of metrics e.g. RWA, EC, investment etc…) to ensure a sufficient return against economic capital.
The last option requires a significant level of additional modelling to allow granular expectations of losses, income (net of funding costs), costs and capital consumption.
The most complex of these requirements are losses and capital consumption (for IRB portfolios). However, the models developed for IFRS 9 impairment can largely satisfy these requirements with minor adjustments. This just leaves the income and costs – fortunately these are generally quite simply modelled through mechanistic calculations and deterministic outcomes, and the model to tie all these pieces together.
Once this model has been produced, the returns and profit expectations of new originations and existing loans under varying economic scenarios can be modeled. Analysis of these estimates by key segments and/or critical scenarios can then be used to identify key segments, concentration risk and help set risk appetite.
At 4most we are already engaging with various organisations to develop these models and our clients are seeing benefits with both their financial performance and modelling sophistication. This is opening doors to further sophistication in a range of areas including marketing, customer retention and portfolio acquisitions. Additionally, for any organisation with IRB aspirations, these models should form the cornerstone for use test requirements and the requirement to embed IRB models and metrics in all areas of the organisation.
4most’s Broad Capabilities