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IFRS 9 : Accounting Meets Risk Management by En Shah Zain

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"IFRS 9 : Accounting Meets Risk Management - Challenged and Solutions for Fixed Income Instruments" was presented by En Shah Zain, Chief Business Officer from Bond Pricing Agency Malaysia during the BPAM Annual Client Update 2016.

Published in: Economy & Finance
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IFRS 9 : Accounting Meets Risk Management by En Shah Zain

  1. 1. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. Bond Pricing Agency Malaysia IFRS 9 : Accounting Meets Risk Management Challenges and Solutions for Fixed Income Instruments ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD - All rights reserved. Presented by Mohd Shaharul Zain Chief Business Officer, BPAM
  2. 2. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. Content 1. Introduction to IFRS 9 2. The Expected Credit Loss Model 3. Data Sources 4. Conclusion and Summary
  3. 3. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. Content 1. Introduction to IFRS 9
  4. 4. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. Phase 1: Classification and measurement of financial assets and liabilities Fair Valuation for fixed income instruments (unchanged from IAS 39 / FRS 139)  IFRS 9 “Financial Instruments” : The replacement of IAS 39 released on 24 July 2014.  Implementation on 1st January 2018 Key Modules: Phase 2 : Impairment Methodology – The Expected Loss Model Phase 3 : Hedge Accounting 1.1 IFRS 9 : Introduction
  5. 5. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. Determine Business Model Treatment of Books AMORTISATION (HTM Book) IMPAIRMENT PROVISIONING VIA EXPECTED CREDIT LOSS MODEL Fair Value Through Profit & Loss (Trading Book) Mark to Market FAIR VALUE THROUGH OTHER COMPREHENSIVE INCOME (AFS Book) IMPAIRMENT PROVISIONING VIA EXPECTED CREDIT LOSS MODEL 1.2 IFRS 9 : New Classification and Treatment
  6. 6. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. 1.3 IFRS 9 : Implications IAS 39 does not evaluate events after the reporting date. On the other hand, ECL looks 12 months beyond the reporting date to evaluate deterioration in credit risk, not other forms of risk (eg interest rate risk) To avoid the problem of provisioning “too little too late” as seen during the Subprime and Euro Debt Crisis. Insufficient provisioning and their sudden realisation led to shocks on financial institutions balance sheets IAS 39 : Incurred Loss Model IFRS 9: Expected Credit Loss Model
  7. 7. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. 1.4 IFRS 9 : Implications Overall, the implementation of IFRS 9 will be a major challenge for everyone holding bonds, sukuk, commercial papers and bills. Large amounts of data sets will be required to evaluate the various asset classes affected. This is less a problem for entities with well developed risk databases compared to those lacking such infrastructure The new numbers reported under IFRS 9 may lead of significant impact in P&L volatility as well as Basel III compliance for capital regulated entities The new method of classification based on the business model of the entity. could have a large impact on financial performance as assets will need to be measured differently
  8. 8. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. Content 2. The Expected Credit Loss Model
  9. 9. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. EVALUATING PERFORMANCE Is there a “significant increase in credit risk’ since initial recognition? USE IAS 39 / MFRS 139 TRIGGERS AS “LOSS EVENT” INDICATORS Disappearance of Active Market Downgrade of Credit Rating Decline of Fair Value below Amortised Cost Local or National economic conditions that correlate to the assets in the group The lender - granting the borrower a concession that the lender would not otherwise consider Significant financial difficulty of the issuer “It may not be possible to identify a single, discreet event that caused the impairment. Rather the combined effects of several events may cause the impairment” 2.1 IFRS 9 : The Expected Credit Loss Model
  10. 10. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. 2.2 IAS 39 / MFRS 139 : Key Excerpts Para 59 A financial asset or a group of financial assets is impaired and impairment losses are incurred if, and only if, there is objective evidence of impairment as a result of one or more events that occurred after the initial recognition of the asset (a ‘loss event’) and that loss event (or events) has an impact on the estimated future cash flows of the financial asset or group of financial assets that can be reliably estimated. It may not be possible to identify a single, discrete event that caused the impairment. Rather the combined effect of several events may have caused the impairment. Objective evidence that a financial asset or group of assets is impaired includes observable data that comes to the attention of the holder of the asset about the following loss events: a. significant financial difficulty of the issuer or obligor; b. a breach of contract, such as a default or delinquency in interest or principal payments; c. the lender, for economic or legal reasons relating to the borrower’s financial difficulty, granting to the borrower a concession that the lender would not otherwise consider; d. it becoming probable that the borrower will enter bankruptcy or other financial reorganisation; e. the disappearance of an active market for that financial asset because of financial difficulties; or f. observable data indicating that there is a measurable decrease in the estimated future cash flows from a group of financial assets since the initial recognition of those assets, although the decrease cannot yet be identified with the individual financial assets in the group, including: g. (i) adverse changes in the payment status of borrowers in the group or (ii) national or local economic conditions that correlate with defaults on the assets in the group
  11. 11. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. 2.3 IAS 39 / MFRS 139 : Key Excerpts Para 60 The disappearance of an active market because an entity’s financial instruments are no longer publicly traded is not evidence of impairment. A downgrade of an entity’s credit rating is not, of itself, evidence of impairment, although it may be evidence of impairment when considered with other available information. A decline in the fair value of a financial asset below its cost or amortised cost is not necessarily evidence of impairment (for example, a decline in the fair value of an investment in a debt instrument that results from an increase in the risk- free interest rate). Para 61 …..objective evidence of impairment…also includes information about significant changes with an adverse effect that have taken place in the technological, market, economic or legal environment in which the issuer operates… Para 62 ….an entity uses its experienced judgement to adjust observable data for a group of financial assets to reflect current circumstances …..The use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability
  12. 12. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. 2.4 IAS 39 / MFRS 139 : Key Excerpts AG84 Impairment of a financial asset carried at amortised cost is measured using the financial instrument’s original effective interest rate…..As a practical expedient, a creditor may measure impairment of a financial asset carried at amortised cost on the basis of an instrument’s fair value using an observable market price AG86 The process for estimating the amount of an impairment loss may result either in a single amount or in a range of possible amounts. In the latter case, the entity recognises an impairment loss equal to the best estimate within the range taking into account all relevant information available before the financial statements are issued about conditions existing at the end of the reporting period AG 87 …. financial assets are grouped on the basis of similar credit risk characteristics that are indicative of the debtors’ ability to pay all amounts due according to the contractual terms (for example, on the basis of a credit risk evaluation or grading process that considers asset type, industry, geographical location, collateral type, past-due status and other relevant factors). AG89 Future cash flows in a group of financial assets …..are estimated on the basis of historical loss experience for assets with credit risk characteristics similar to those in the group reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability
  13. 13. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. IAS 39 / MFRS 139 LOSS EVENT TRIGGERS (RELEVANT TO FIXED INCOME INSTRUMENTS) Disappearance of Active Market Downgrade of Credit Rating Decline of Fair Value below Amortised Cost Local or National economic conditions that correlate to the assets in the group The lender….granting the borrower a concession that the lender would not otherwise consider Significant financial difficulty of the issuer OBSERVABLE DATA FROM BOND MARKET Trades/Liquidity Score - Compared to whole market / peers) Credit Rating – Actions during period Probability of default and migrations – Rating agency data Prices and Yields – Compared to peers Index Performance – Credit class vs general market trends BIR – Notch differential / period 2.5 IFRS 9 : Application to Fixed Income
  14. 14. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. Content 3. Data Sources
  15. 15. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. Trigger: Disappearance of Active Market  Evaluate if there is an active market  Compare liquidity relative to the market as a whole and other similar bonds  Consider turnover ratio  Source: BPAM Bond Transparency Tool . LIQUID ILLIQUID 1 5 No. of Trades Total Trades Turnover Ratio Trade Recency Trade Frequency Trade Turnover SCORING 3.1 Data Sources : Liquidity Scores and Trade Data
  16. 16. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. Trigger: Downgrade of Credit Rating  Ratings performance since recognition are an important source of information, but may be lagging  Source: BondStream Para 60 A downgrade of an entity’s credit rating is not, of itself, evidence of impairment, although it may be evidence of impairment when considered with other available information. 3.2 Data Sources : Credit Ratings
  17. 17. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. Trigger: Downgrade of Credit Rating  Ratings migration and default studies over the years give a probabilistic perspective on deterioration in quality  The BPAM Default and Rating report covers the entire RAM/MARC universe on a quarterly basis  Source: DaRT Report 3.3 Data Sources : Migration and Default Studies AG89 Future cash flows…..are estimated on the basis of historical loss experience for assets with credit risk characteristics similar to those in the group
  18. 18. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. Trigger: Decline of Fair Value below Amortised cost  Historical price and yield performance relative to peers and the market as a whole  Consider if declined or increased relative to amortised value, and for how long (sustained or temporary)  Source: Bond Pricing Service 3.4 Data Sources : Historical Price and Yield Analysis
  19. 19. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. Rating Trigger: The lender….granting the borrower a concession that the lender would not otherwise consider…. Significant financial difficulty of the issuer  Captures specific risk profile of issuer and industry, showing market perception of under or over performance relative to peers  Source: BPAM Bond Transparency Tool 3.5 Data Sources : Issuer Specific Yield Analysis
  20. 20. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. Trigger: Local or National economic conditions that correlate to the assets in the group….information about significant changes with an adverse effect that have taken place in the technological, market, economic or legal environment in which the issuer operates…  Indices provide a barometer of macro market conditions and can be used to determine if a certain credit class is underperforming relative to its peers  Source: TR-BPAM Index Series 3.6 Data Sources : Indices
  21. 21. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. AAA AA A BBB Bonds Bond: A Tenure: 1 Year Credit Rating: AAA BIR: BBB Bond: B Tenure: 5 Year Credit Rating: AA BIR: AAA Bond: C Tenure: 10 Year Credit Rating: AA BIR: AA BIR Regions Tenure YTM-MGSSpread Implied Ratings are a market-perceived credit rating, implied via market statistics and calibrated via financial mathematics Trigger: The lender….granting the borrower a concession that the lender would not otherwise consider…..Significant financial difficulty of the issuer  Market reacts immediately to issuer specific news, some of which may be privileged  Sustained negative divergence (ie IR < CR) is a strong leading signal of possible credit related problems  Comparison between CR and IR thresholds can give a theoretical range of loss values as a guide to provisioning  Source: BPAM Market Implied Ratings 3.7 Data Sources : Implied Ratings
  22. 22. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. Content 4. Conclusion & Summary
  23. 23. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. Data sets and statistical values to support the impairment provisioning decision for fixed income instruments OUTPUT Trades/Liquidity Score Credit Rating Evaluated Price/Yield Index Performance Implied Ratings Probability of default DATA SOURCES Disappearance of Active Market Downgrade of Credit Rating Decline of Fair Value below Amortised Cost Local or National economic conditions that correlate to the assets in the group The lender….granting the borrower a concession that the lender would not otherwise consider Significant financial difficulty of the issuer KEY IMPAIRMENT TRIGGERS 4.1 Summary
  24. 24. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. KEY DATA SETS NEEDED TO CALCULATE EXPECTED CREDIT LOSSES: TRIGGER DATA PROBABILITY OF DEFAULT LOSS GIVEN DEFAULT CASH FLOWS ORIGINAL EFFECTIVE INTEREST RATES 4.2 Conclusion
  25. 25. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. IT’S ALL ABOUT DATA THE SUCCESFUL IMPLEMENTATION OF IFRS 9 IN AN ENTITY IS FUNDAMENTALLY DEPENDENT ON THE AVAILABILITY OF DATA THAT IS: TIMELY GRANULAR ACCURATE ACCEPTED BY THE AUDIT INDUSTRY EFFICIENTLY FORMATTED AND DELIVERED 4.3 Conclusion
  26. 26. ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD. - All rights reserved. THANK YOU No 17-8 & 19-8 , The Boulevard, Mid Valley City, Lingkaran Syed Putra, 59200 Kuala Lumpur, Malaysia Tel: +603 2772 0889 Fax: +603 2772 0808 Email : enquiries@bpam.com.my ©Copyright BOND PRICING AGENCY MALAYSIA SDN.BHD - All rights reserved.

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