Moscow, January 31, 2019 — Business Systems Consult. IFRS 9 prescribes to choose an accounting methodology basing on the business model analysis. However, many consultants who focus on accounting treat this requirement formally and narrow. In fact, such consultants explain on the client’s account that a loan is a loan. But a business model is a conceptual tool that expresses a company's logic of earning money (A. Osterwalder). The failure to explicitly specify the business model turns into low-quality corporate governance, higher and unperceived risks, losses.

A comprehensive analysis of Basel regulations shows that there are

•     two business models for commercial lending (regular clients and SME clients in corporate loan portfolio),

•     five business models for specialised lending (project finance, object finance, commodities finance, income-producing real estate, and high-volatility commercial real estate).

However, practical experience shows that even for the effective interest rate calculation, at least three business models should be specified. This specification is a basis for a risk-based pricing, funding optimisation, and client relationship planning. A separate article discusses this issue in detail.

It is worth to do the job of comprehensive business model specification as compared to simple swear that loans are not sold from the loan portfolio!

How does an exemplary business model specification look like?

Curiously enough, but the exemplary specification is presented in the corpus of regulatory documents that neglected the IFRS for long time. It is presented: Basel document d457 Minimum capital requirements for market risk. Contrary to the many other Basel documents, this directly mentions IFRS 9 (see RBC25.9, footnote #2, here and further these references to the d457 document).

This document explores in depth what a trading book is. It should be stressed that there is an equivalency between the notion of trading book in d457 and the assets measured at fair value through profit or loss (cf. RBC25.4). The trading book specification is a source of inspiration for business model specification.

Any business model specification should cover the following aspects:

•     the purpose of financial instruments for the entity,

•     the signs that the financial instruments de facto correspond to the specified business model,

•     a list of financial instruments that have to be considered under the business model,

•     a list of financial instruments that have not to be considered under the business model.

The role of risk management in financial instrument classification appears to be underestimated and may be discussed in a separate article. But Basel d457 highlights the importance of risk specification in business model.

In conclusion.

1.  Comprehensive business model specification solves managerial problems. IFRS 9 is a powerful instrument to do it.

2.  It helps to increase the profitability in banking because it intensifies the resource utilisation, optimises funding structure and a level of risks taken.

3.         It reduces operational costs because accounting is aligned with the real economic contents of financial instruments and does not contradict to the mathematical models of risk applied in regulation and management.

If you have any questions or you are responsible for effecient, self-consistent, and comprehensive implementation of IFRS and Basel market risk regulatons in your bank, please, do not hesitate to contact us!

Russian version of this article.

Other insights:

IFRS 9, Scoring Calibration and a Typical Error

IFRS 9: How to Efficiently Implement It in 75 Days