As the economy is entering a new digital era, financial institutions are preparing for change from centuries-old accounting conventions to new credit risk models. IFRS 9 is designed to promote a stable financial system, the new standard was published by the International Accounting Standards Board and kicks in from 1st January 2018.
For now the current IAS 39 standard utilises an incurred loss model – limited by only recognising credit losses once there has been an incurred loss event. As a result expectations of future credit losses are not taken into consideration. During the financial crisis, IAS 39’s weakness caused delays in the recognition of credit losses on loans, in response, IASB prioritised development of IFRS 9.
The mandatory standard enforces changes to banking business models in three main areas including classification and measurement, impairment and hedge accounting.
Classification and Measurement
The many classification categories and associated impairment models in IAS 39 often resulted in application issues. Based on feedback received, the IASB decided to replace the classification and measurement categories so that each asset will be assigned to one of the following:
- Amortised cost
- Fair value through other comprehensive income (FVTOCI)
- Fair value through profit or loss (FVTPL)
An assessment of contractual cash flow features contained in each financial asset will determine which category applies. The contractual cash flow needs to meet SPPI criterion for the asset to qualify as either Amortised Cost or FVTOCI. If it fails to meet SPPI criterion such asset will be classified as FVTPL.
Assessments of impairment are changing from an incurred loss accounting model (IAS 39) to an expected credit loss (ECL) model (IFRS 9). Entities will be required to consider historic, current and forward-looking information (including macro-economic data). IFRS 9 outlines a three stage model for provision/impairment based on credit quality since the day the loan was extended. Currently banks have impaired and non-impaired accounts when provisioning loans. Under IFRS, the non-impaired accounts will have to be split into two stages (Stage 1 or 2):
Stage 1: healthy loans
For accounts that fall under Stage 1, the bank has to provide 12-month forward-looking ECL – an expected credit loss that results from default events that are possible in the 12 months since reporting date. Borrowers with a good credit risk profile will likely fall under this category.
Stage 2: underperforming loans
Stage 2 is more problematic for banks as provisions can potentially get four or five times heavier than Stage 1. Banks have to provide lifetime ECL – an expected credit losses that result from all possible default events over the expected life of the loan.
Stage 3: nonperforming loans
Accounts will fall under this category when there is “significant increase in credit risk” since the loan was extended. Banks will carry out lifetime ECLs plus a cut to future interest revenues.
Within each reporting period, the probability of default (PD) of loans are checked and banks must increase provisions if an increase in PD is found between reporting periods. Provisioning of loans could jump significantly, however, to deal with the volume banks may re-price or restructure the loans, making it more difficult for borrowers with riskier credit profiles. Banks might think twice about extending certain types of loan facilities if they are deemed too risky or no longer profitable - this could include reducing the limit of undrawn facilities such as overdrafts.
Investors, and others, will agree that the current hedge accounting requirements are too rule-based and arbitrary. This will change to a more principle-based approach, under IFRS 9 and will allow hedging to be more aligned with the entity’s risk management framework.
Companies that have rejected using hedge accounting because of its complexity under IAS 39 could find the new requirements more accommodating. IFRS 9 will allow investors to better understand the effect of hedging activities on the financial statement and on future cash flows.
Financial institutions could find the mandatory IFRS 9 requirements challenging. Implementation requires subject matter experts to carry out complex tasks such as designing and building an automated system, continually monitoring and updating test results and documenting and maintaining a defensible audit trail.