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IFRS 9: How to Efficiently Implement It in 75 Days

Moscow, March 07, 2018 — Business Systems Consult. How to make structure IFRS 9 project? What components should it include? What aspects has it to cover?

Quantitative assessment of credit risk is one of the most difficult risk management activities. It can be absent in many entities. This complicated mathematics might appear to be wasting of resources without any benefits for the entity. Many banks think about IFRS 9 and Basel implementation as a cost of license and a mean to soften regulatory pressures on capital at the account of regulatory arbitrage.

However, this project approach is incorrect. The aim of regulation is not to create difficulties for business. The ultimate aim is to spread the best practices of management to foster efficiency and stability of business entities. Therefore, quantitative methods of credit risk assessment should be applied to management problems, not to only regulation purposes. This requirement has direct effect in Basel (see §444 in bcbs128). Treating IFRS 9 as a cost is a sign of incorrect implementation approaches focusing on credit allowance calculation. The correct approach is to treat IFRS 9 implementation as an investment in business efficiency directed at:

• deep data analytics,

• acceleration in decision making,

• decrease of erroneous credit decisions leading to losses,

• precise risk-based pricing,

• increase in quality of it-systems.

Efficient implementation of IFRS 9 should be a by-product of credit business improvement. The secondary character of IFRS 9 implementation (which is not, however, a sign of low quality) is a feature of efficient IFRS 9 implementation. By the way, it is a requirement of the Standard (see pp. 5.5.9, 5.5.11, 5.5.17, implementation should be without undue cost or effort).

Components of IFRS 9 Implementation

Any project is a set of tasks. What tasks should be accomplished to implement IFRS 9 in a bank or leasing company. The structure of the Standard puts forward the list of tasks.

IFRS 9 implementation starts from business models and SPPI test. The most typical business models according to IAS 39 are HTM and AFS. Despite commonly held view, these business models are not canceled with IFRS 9. The importance of SPPI test is overestimated (we have a separate article on the issue). However, the need to declare business models carries big opportunities to review business strategy, asset and liability optimisation, investment statements.

The next (and probably parallel) step is construction of models for borrower (lessee) risk estimation. These models correspond to segmentation of credit products; this segmentation is also an outcome of the IFRS 9 project. There are 3 approaches to risk quantification. Under collective approach past due amounts of borrowers are analysed. In this case, Babikov’s decomposition helps to identify macroeconomic effects. This methodology completely satisfies IFRS 9 requirements without omissions and simplifications. Under individual approach quantitative measurements of borrower’s credit risk can be obtained either as a result of scoring card (but the scoring card is a product of collective analysis) or by direct financial modeling (usually this model generalises the financial model of the borrower and uses Monte Carlo techniques).

Behaviour of borrowers should be analysed even in case of individual allowance calculation. One of the most important sources of retention is simply return of the distressed borrower to the contract cash flow.

Risks associated with the leased object or object of collateral should me also modeled. Ideally, regular valuation procedures should be applied to collaterals. The rate of regularity has to be equal to the frequency of IFRS 9 reporting (eg, quarterly). In practice, it is too expensive and can not be realised. Instead, these procedures may be replaced by valuation models whose task is to adjust the last valuations to the reporting date with the precision required for allowance calculation. These models are especially important when IFRS 9 is applied in cooperation with IFRS 16 to leases.

A special regulation should be developed in IFRS 9 implementation project. This document has to specify a standard business process of collateral withdrawal and its sale in case of default. In practice, there are 100 500 motivations to abstain from immediate withdrawal and sale of the collateral in a particular defaulted deal in accordance with this document. The bank or leasing company may prefer to restructure the credit facility. This document is mainly needed for risk management. Basel specifies credit policy development and contents. In particular, this document has to define when collateral is “withdrawn”. If it is “withdrawn” and sold in 90+ past due (a standard default definition), there is no space for a distressed borrower to restore his or her behaviour. Therefore, on of the sources of retention is neglected, and credit allowances will turn to be overestimated. If withdrawal is too late, there is risk of low value of collateral due to natural amortisation. Although this document may be far from the real cases of dealing with loans in arrears, it should present a really available procedure. Moreover, if there is statistics for dealing with collateral (not rare cases), it should support the decisions prescribed by this document.

All enlisted models build a solid basis for IFRS 9 methodology (separately for collective and individual calculations).

Regulations and Documents in IFRS 9 Implementation

To implement is to document. Credit allowance calculation is cooperation of financial departments and risk management. Several IFRS 9 business processes should cover preparation, realisation and further monitoring of credit or leasing deals. Corresponding regulations should be developed.

How to calculate is an issue of methodologies.

Explanatory notes are required to justify the methodological decisions and to assure that all the requirements of IFRS 9 (in methodological parts) and Basel (in parts of business processes) are met.

IFRS 9 changes asset liability management and non-operating cost accounting. Although these regulatory documents are out of the project scope, they are to be reassessed.