IFRS 9: How to Save Capital Adequacy

Moscow, January 03, 2018 — Business Systems Consult. How to make IFRS 9 allowances good enough to prevent destroying capital adequacy ratios? How to prevent excessive provisions? What should be done before the first reporting in accordance with IFRS 9?

IFRS 9 is acting starting from January 01, 2018 and its implementation imposed significant shifts in methodologies of allowance calculation both on individual and collective basis. As a result, provision amounts change. Capital adequacy deterioration forecasted by many analysts stimulated Basel Committee to widely discuss IFRS 9 implications (see for example d401 — Standards. Regulatory treatment of accounting provisions — interim approach and transitional arrangements).

Although IFRS 9 implementation is not completed even now (in January of 2018; for example, no regulator in major economies bases its capital requirements on IFRS 9), external users of financial reporting (investors, rating agencies, counterparties) will definitely assess capital adequacy basing on IFRS 9 right away. Therefore expected losses calculated in accordance with IFRS 9 matter.

Capital Adequacy Problems with IFRS 9 allowances on a collective basis

The major effect of credit risk on allowance volume is maturation effect. This effect should be taken into account in accordance with IFRS 9 paragraphs B5.5.5(e), B5.5.10, B5.5.17 (a, e, p). Macroeconomics, credit quality, collection efforts are secondary effects although they should be also estimated according to the Standard. The terminate IFRS 9 provision amount will be almost the same as IAS 39 one. The only difference is maturation: IFRS 9 allowances designate expected losses earlier.

What should be done to prevent all unexpected consequences of IFRS 9 transition? Evidently, it is not enough to simply calculate allowances as of October 01, 2017 (for example) and pin faith to stability of this figure. Allowance calculation is not a matter of faith. Maturation can be significant (the presented figure demonstrates that allowance amount may grow by 30% in a quarter). Therefore, efficient IFRS 9 implementation project should include budgeting. In other words, a Bank should build Asset-Liability Management (ALM) technology taking into account IFRS 9. ALM procedures should be corrected as a result of efficient IFRS 9 implementation.

How to Manage Credit Provisions under IFRS 9?

Banks usually segment their loan portfolios for separate collective and individual assessment of allowances. Collective approach has several advantages:

+   it is forward-looking, and measuring of its forward-looking ability does not carry any undue costs because it is based on statistical approaches;

+   it is technologically easier as it does not require individual analysis and data management for separate borrowers.

Individual allowance assessment is inevitable for the unique distinguished loans. Individual analysis based on the scenario assumptions (they may be arbitrary to some extent) may justify the total provision amount. Any auditor knows it very well.

However, in reality collective approach to provision management is more effective and efficient. In accordance with paragraphs 5.5.4, 5.5.17(c), 5.5.18 of the Standard credit allowances should reflect reasonable and supportable information on forecasts of future economic conditions. The choice of reasonable macroeconomic scenario determines provision amount. The only prerequisite is to possess a technology that makes collectively calculated allowances management possible.

Three Sources of Undue Excesses in Credit Allowances

Banks make several methodological simplifications while implementing IFRS 9. Not all of such simplifications are harmless for capital efficiency (and therefore, shareholders).

Precise Accounting for Cash Flow Schedule May Allow to Decrease Provision Amount by 20%

Banks often apply Basel expected loss formula (EL = PD × LGD × EAD). It gives provision amount of 5% of a value for a loan with 0.05 average probability of default and loss-given-default value 1.

However, if a borrower pays its debt quarterly on equal amounts within 2 years, and interest rate is 10% p. a., expected losses in accordance with paragraph B5.5.29 of the Standard will be 3.9% of the loan value.

Even if the loan is bullet-at-maturity, the provision rate will be lower than 5%. The source of the gain is discounting at the efficient rate.

It should be reminded that according to paragraph B5.5.29 of the Standard the credit loss is the difference between the present value of the contractual cash flows and the cash flows that the entity expects to receive.

If You Refuse to Estimate PD and LGD Separately, You Duly Decrease Your Provisions by 10%

IFRS 9 does not contain a term “loss-given-default”. Consequently, the models applied by a bank for allowance calculation may model expected loss in a different way than Basel. Since the events of default and default recovery are dependant (the loss given default depends on default probability), expected loss modelling as a product of independently estimated PD and LGD is only approximation.

Our estimations show that direct modelling of expected losses prevents undue increase in credit loss estimations by 10%. This approach is actually acceptable according to §398 of Basel requirements (see bcbs128 — International Convergence of Capital Measurement and Capital Standards).

Portfolio Segmentation Should Be Statistically Justified

Collective approaches work well when a portfolio consists of a large number of loans. However, portfolio segmentation can be based not only on IFRS 9 requirements but also on managerial needs or historical issues. These needs may be not related to the IFRS 9. As a result, some portfolios do not contain enough data, and the reasons have nothing in common with IFRS 9 and allowance calculation. Implication of individual approaches tends to overestimate allowances.

Application of the segmentation specially developed for IFRS 9 increases modelling quality and helps to reduce provisions duly, in accordance with IFRS 9 requirements.

Originally published in Russian.

To read more:

How Is Your Bank Prepared for IFRS 9 Implementation?

To read more about methodology for IFRS 9 click here.

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Опубликовано 03 Jan 2018 Author Magister ludi

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