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|By Rocky Lim-Director, Risk Consulting KPMG in Vietnam|
IFRS 9 represents a new era of expected credit loss provisioning. The global financial crisis 12 years ago highlighted the systemic costs of delayed recognition of credit losses by banks and lenders. These delays ultimately resulted in the recognition of credit losses that were widely regarded as “too little, too late”.
Following the crisis, G20 leaders, investors, regulatory bodies, and prudential authorities called for action by accounting standard setters to improve loan-loss impairment standards and practices.
After intensive deliberations and consultations, the International Accounting Standards Board (IASB) ultimately responded to the G20’s call to action, and in 2014 published IFRS 9 as the new standard for accounting for financial instruments. The most significant innovation is the introduction of the expected credit loss (ECL) impairment model when recognising loss allowances, which aims to promote earlier recognition of credit risk.
The new impairment approach now requires banks to recognise expected credit loss (ECL) and to update the amount of ECL recognised at each reporting date to reflect changes in the credit risk of financial assets. This new approach is forward-looking and eliminates the threshold for the recognition of credit losses, so that it is no longer necessary for a ‘trigger event’ to have occurred before credit losses are reported.
Apart from historical and current information, for the first time forecasted macroeconomic information such as GDP growth, unemployment rates, and house pricing index must be considered when generating weighted probability.
Business impacts of IFRS 9
Most stakeholders believe that IFRS 9 will have a significant impact on loan-loss allowance, earnings, and capital given that ECL will be measured using macroeconomic forecasts that are inherently uncertain. In addition, IFRS 9 introduces the concept of “staging”. When a borrower experiences a material deterioration in credit quality (but continues to perform), and an associated financial asset transitions from stage 1 to stage 2, loan-loss allowance increases from 12 months to a lifetime expected loss.
Based on KPMG implementation experience on IFRS 9, commonly observed business impacts include several factors.
First is increased volatility in credit cost. Reported ECL are more volatile given its inherent forward-looking nature and banks are expected to focus on better credit cost discipline. Over each quarter or reporting interval, banks have had to explain ECL estimates which exhibited procyclicality swings as financial assets are systematically shifted from stage 1 to stage 2.
Second is higher credit cost in retail books. Banks experienced higher credit costs on credit cards with large undrawn and underperforming mortgage loans with longer tenure. At the origin, banks have consistently allocated higher risk premium in their pricing mechanism to cover higher credit cost for retail book, and have had to learn to manage external headwinds from weakening property prices and unexpected distressed drawdown due to deteriorating household income during COVID-19.
The third and final factor is post-model overlay on ECL impairment due to COVID-19. Guided by IASB, banks have attempted to reflect different macro scenarios and their associated weightings, in order to quantify the pandemic’s impact on ECL impairment model estimates.
Existing models previously built on periods of benign economic condition may not effectively handle COVID-19 macroeconomics, and senior management have had to apply post-model overlay to meet IFRS 9 expectations.
What banks should do now
Given the uncertainties associated with implementation of the new and far more complex ECL impairment models, we recommend banks to plan now and prepare themselves for any negative impact to business models and stability of bank’s operation. A high-quality implementation plan should cover four points.
First is IFRS 9 programme governance, with banks to establish-board level project sponsorship and engagement followed by strong senior management lead of implementation projects (typically the finance-lead or risk-lead). Next is a financial impact assessment on ECL, with banks to determine impact assessment methodology by customising modelling approaches for material portfolios with extrapolation for smaller books.
Third is IFRS 9 gap analysis. Banks should conduct assessment of current state in terms of models and methodologies, including the review of data availability and data quality.
Finally is IFRS 9 Roadmap formulation. Banks must prepare a multi-year implementation roadmap for senior stakeholders, highlight key dependencies, and maintain flexibility for early adoption.
Based on the observed implementation journeys of successful adopters, the technology for IFRS 9 has had a variety of key impacts on the way that banks operate in the three main areas of data, computation, and languages/modelling environment.
Most banks have had to upgrade their calculation environments; some may even have had to run different calculation environments in parallel. In addition, banks have had to carry out many stress tests, especially what-if scenarios to understand their ECL impairment model sensitivities.
Finally, as new ECL impairment models have become more demanding, there has been rapid growth in use of new computing languages or an expansion in traditional mathematical languages. To develop an effective, lasting technology solution, banks must repurpose their existing tools, extend their standardised features, make use of new and flexible open-source computing languages, and develop a clear and well-articulated data strategy, which is essential if they want flexible, scalable models.
Banks also need to take a holistic view of the credit lifecycle, and view these developments as part of a deep sea-change in risk and finance – one that will affect the way they operate for decades to come.