It’s no secret that the countdown is now on for the implementation of the new, global accounting standard, IFRS 9 which must be implemented and fully compliant by January 2018.
Amongst other things, IFRS 9 addresses how to recognise and account for credit losses (impairment) and will require serious thought, co-operation and investment from the industry, not only to meet the requirements but also to reach the end goals that is has been designed to achieve.
The new standard is a distinct departure from the current International Accounting Standard 39 (IAS 39) Financial Instruments: Recognition and Measurement, in that it focuses on accounting for expected credit losses as opposed to incurred losses.
Criticisms levied at the current standard
There have of course been a number of criticisms levied at the current standard, namely;
- It was slow to respond to recognition of credit losses, specifically only recognising lifetime expected credit losses on exposures where there was objective evidence of impairment and an additional allowance (incurred but not reported) for exposures expected to become impaired imminently.
- That it was too reliant on backward looking information, particularly delinquency data and historical loss rates.
- That it only considered drawn loans, not commitments to lend. As a result many credit card and current account providers were not recognising sufficient loss allowances.
- That the information provided to users of financial statements is not transparent enough to be useful.
- It was too complicated to implement and maintain as there were multiple approaches depending on the asset.
The move to change it was escalated as a result of the financial crisis of 2007 / 2008 and the fall out we have seen in terms of banks having to be bailed out by public money and failures of countries, such as Greece for example, to repay their debt.
What the new standard IFRS9 aims to address
The new standard attempts to address these issues in a number of ways;
- IAS 39 was slow to respond by design. It was a response to some organisations applying balance sheet management under UK GAAP to recognise losses that would not be incurred in good times so that they could be released to prop up the P&L in bad times. IFRS 9 addresses this by recognising lifetime expected credit losses for all exposures that have objective evidence of impairment, all exposures that have significantly increased in risk since initial recognition and exposures that are expected to default in the next 12 months.
- The standard demands that forward looking information is used and losses are accounted for now on the basis of what we believe will happen in the macro – economic environment in the future and, the specific impact that has on an organisation’s different portfolios.
- Under IFRS9, the date of recognition is the date at which the commitment to lend is made. This means that for pipeline business and revolving credit products, losses must be recognised based on the expectation of draw down over the behavioural life of the exposure.
- The disclosure requirements are more granular, requiring split by Risk grade, LTV, drawn and undrawn.
- There is a single impairment model for assets measured under amortised cost and those measured under Fair Value Other Comprehensive Income (FVOCI).
Could we really have prevented the global financial crisis in hindsight?
So, a legitimate question is, if IFRS 9 was in place in 2007 / 2008, would it have prevented the global financial crisis, and for example the distressed restructuring of Greek debt?
To answer this we need to think about the reasons for the crisis and the debt. There are various different opinions but it could be said to be a consequence of five things;
- Poor fiscal management by the Greek government of public finances.
- Endemic tax evasion by the Greek public.
- Heavy investment in Greek bonds at an unsustainable rate following the fall of the US Sub-Prime Mortgage market due to perceived low risk of Eurozone government bonds.
- Financial institutions being slow to react to recognise losses and not allowing for them.
- Lack of liquidity in financial markets.
IFRS 9 will not address the first three at all as the changes are focused on financial institutions and losses resulting from providing credit, not mismanagement of public funds, the level and availability of those funds or how financial institutions source funds to provide credit.
IFRS 9 won’t solve problems in isolation
In terms of the last two, the standard can address these, but not in isolation. IFRS9 provides the principles to allow you to recognise losses early and account for them. If more money is set aside in ‘good times’ to account for future losses, there should not be as much of a squeeze when things start to go wrong, generally meaning that there is more access to credit when required and fewer issues with liquidity. There is a risk however that a poorly implemented model will lead to more volatility and a risk that credit is not available when required.
If the model you develop to do this is shown to be a good predictor of the individuals or portfolios inherent risk that is the first step. To be compliant and to allow it to be useful for internal planning you also need to be able to use that information and your view of the macroeconomic outlook to determine how that risk will change over time, based on movement in unemployment rate, changes to interest rate, changes to price indices etc.
Burden or opportunity?
So how do you know if your view of the world agrees with everyone else’s? How do you know if your models are performing to the right level, given they have not previously had to predict the future? How do you know that your disclosures are on the same basis and provide the same level of transparency as your peers?
It is incumbent on you to develop the right tools, based on the right methodology and present the results in the appropriate way. This will require knowledge of the industry, how the standard has been interpreted and experience of delivering solutions that work for you and meet regulatory expectations and industry approval through benchmarking.
There is no panacea to preventing these crises but this is certainly another legislative backstop which will require banks to hold bigger provisions and capital than they have in the past. Rather than see this as a burden to be borne by the industry it could be seen as an opportunity. If it is implemented correctly it can lead to good financial planning, better pricing of assets, more transparency to investors, more stability in the industry and a safer world of banking for all.
By Damien Burke, head of regulatory practice at 4most Europe (www.4-most.co.uk)
About 4most Europe (www.4-most.co.uk)
4most Europe Ltd is a specialist credit risk analytics consultancy with offices in London and Edinburgh. The company provides a range of products and services across credit risk, fraud and pricing, working with blue chip clients predominantly in the retail banking and mobile sectors. The company offers a flexible, competitive model, either working with clients to manage regulatory change or delivering and implementing business critical solutions.