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Credit Impairment under IFRS 9 for Banks

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A quick overview of credit impairment under IFRS 9 for banks. Those with limited or no understanding of new requirements for loan loss accounting, will get a quick high level understanding of an accounting standard that is the most significant change in accounting for loan losses in more than a decade.

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Credit Impairment under IFRS 9 for Banks

  1. 1. A Quick Overview Credit Impairment under IFRS 9 for Banks
  2. 2. Classification and Measurement Impairment Hedge Accounting IFRS 9, IASBs new accounting standard on financial instruments, will replace IAS 39, effective January 1, 2018. It contains three areas of accounting for financial instruments as shown in the diagram. This presentation addresses ‘Impairment’, from the point of view of banks. Introduction
  3. 3. By the end of this presentation, you will be able to: • Describe what is the new expected credit loss model under IFRS 9 • What are the 3 stages of accounting for credit losses and interest income • What are the practical expedients allowed What will you learn?
  4. 4. I. Credit loss model III. Practical expedients II. Stages IFRS 9, replaces IAS 39 for recognizing credit losses in banks accounting books. Under IFRS 9, the approach for measuring credit risk and accounting for it has changed fundamentally from incurred loss model to expected credit loss model and carries the following 3 key components Key Components
  5. 5. Previous to IFRS 9, an allowance for credit losses used to be estimated based on historical data, such as, delinquencies in repayments, impairment in collateral or other adverse conditions of the borrower. This is called the incurred loss model. Meaning, the loss or conditions had already occurred before the allowance was booked. Incurred Loss Model I. Credit loss model III. Practical Expedients II. Stages
  6. 6. Credit loss model A criticism from 2008 financial crisis, was that the banks recognized credit loss allowance too late, i.e., based on historical information. IFRS 9 introduces expected credit loss model, a forward looking model, to recognize credit losses expected over the life of the loan. As a result, credit risk of a bank is more timely reflected in its financial statements. Expected Loss Model (Contd.)
  7. 7. Credit loss model In a forward looking model, the banks will now have to estimate the expected credit losses before credit events have taken place. In next slide you will see the 2 factors used in estimating expected credit losses under IFRS 9. Expected Loss Model (Contd.)
  8. 8. Probability of Default Expected Loss Reasonable and Supportable Information The expected credit losses (ECL) are estimated from the product of 2 factors: PD: This is the weighted average of probability of losses from various scenarios EL: Present value of expected losses (or PV of shortfall in cash over lifetime of asset) IFRS 9 requires above to be calculated using reasonable and supportable information from past, present and future (e.g. economic outlook) Factors in Calculating ECL
  9. 9. Credit loss model Banks already usually follow some estimation model, for capital planning, pricing or regulatory requirements, e.g. capital adequacy, stress testing, scenario analysis etc. IFRS 9 aligns the above with accounting so that more useful information is presented to the users of bank’s financial statements. Expected Loss Model (Contd.)
  10. 10. Credit loss model There are also financial statements disclosures requirements that have to do with explaining: - How the expected credit losses were estimated, and - How was credit risk (or changes thereto) were assessed Expected Loss Model
  11. 11. I. Credit loss model III. Practical Expedients II. Stages Second component is the Stages. IFRS 9 establishes 3 stages for accounting for expected credit losses: Stage 1- Initial recognition Stage 2- Significant increase in credit risk Stage 3- Credit losses incurred Stages (Contd.)
  12. 12. Stage 1 Stage 2 Stage 3 Stages (Contd.) Recognize 12 months expected credit losses Recognize lifetime expected credit losses Recognize lifetime expected credit losses Recognize interest revenue as effective interest on gross carrying amount Recognize interest revenue as effective interest on gross carrying amount Recognize interest revenue as effective interest on amortized cost carrying amount
  13. 13. Stage 1 Stages (Contd.) Recognize 12 months expected credit losses Recognize interest revenue as effective interest on gross carrying amount In Stage 1, at the initial recording of the loan, the credit losses expected as a probability in the next 12 months (at reporting date) are recognized in P&L. Interest income during this time is recognized at effective interest rate applied to the gross carrying amount of the loan.
  14. 14. Stage 2 Stages (Contd.) Recognize lifetime expected credit losses Recognize interest revenue as effective interest on gross carrying amount In Stage 2, the credit losses expected over the lifetime of the loan, are recognized in P&L, if there is a significant increase in credit risk. There is no change in how interest income is recorded.
  15. 15. Stage 3 Stages (Contd.) Recognize lifetime expected credit losses Recognize interest revenue as effective interest on amortized cost carrying amount If the credit quality of the loan deteriorates further to the point that credit losses are actually incurred or that there is an actual credit impairment the loan moves to stage 3. In Stage 3, there is no change in accounting for credit losses. Interest income, however, now is recognized based on gross carrying amount minus the loss allowance (amortized cost).
  16. 16. Time Horizon You must have noted, that for recognizing expected credit losses, there are 2 time horizons. The 12 month horizon for recognizing expected credit losses is for the probability of default within the next 12 months (Stage 1). However, when there is significant increase in credit risk for a loan or a group of loans, the bank will have to recognize the expected credit losses for the lifetime of the loan(s) at the reporting date (Stages 2 & 3). Stages (Contd.)
  17. 17. 3 Stages To recap, lets look at the 3 stages again Stages (Contd.)
  18. 18. Stage 1 Stage 2 Stage 3 Stages Recognize 12 months expected credit losses Recognize lifetime expected credit losses Recognize lifetime expected credit losses Recognize interest revenue as effective interest on gross carrying amount Recognize interest revenue as effective interest on gross carrying amount Recognize interest revenue as effective interest on amortized cost carrying amount
  19. 19. I. Credit loss model III. Practical Expedients II. Stages Now lets look at what are the practical expedients under IFRS 9 Practical Expedients (Contd.)
  20. 20. Credit loss model Practical Expedients Stages Some relief has been provided in implementing IFRS 9, so to make it easier for a wide range of companies (banking and non-banking). Three practical expedients are highlighted next. Practical Expedients (Contd.)
  21. 21. 3 practical expedients allowed under IFRS 9 Practical Expedients (Contd.) Information Set Low Credit Risk > 30 Days Past Due Information Set Low Credit Risk Past Due Rebuttable Presumption
  22. 22. Information Set IFRS 9 allows for using information that is easily available to the organization without incurring high costs. This is particularly true for small organization which does not have resources for more sophisticated data analysis. However, for large internationally active banks, Basel guidance (see link below) on expected credit losses, indicates that such banks should not have to use this practical expedient as they already utilize sophisticated data. www.bis.org/bcbs/publ/d350.pdf Practical Expedients (Contd.)
  23. 23. Low Credit Risk If the credit risk was low at the time of loan origination as an example, there no need to assess credit risk at reporting date and it can be assumed that the risk was still low. E.g. US treasuries Basel guidance expects the large international banks to not use this practical expedient and assess all loans for significant increase in credit risk. Practical Expedients (Contd.)
  24. 24. Past Due Rebuttable Presumption If a loan is more than 30 days past due, there is a rebuttable presumption that the credit risk has increased significantly and the banks will have to recognize life time credit losses. For large international banks, Basel guidance points out that 30 days past due is a lagging indicator, so it should not be the primary factor for estimating expected credit losses. Practical Expedients
  25. 25. Credit loss model Practical expedients Stages To recap all what we learnt: IFRS 9 replaces IAS 39, effective Jan 1, 2018. It introduces a new forward looking credit loss model. It prescribes 3 stages of accounting for credit losses depending on credit risk and losses incurred. It provides some relief in implementation, however, Basel expects internationally sophisticated banks to not use these practical expedients. In Summary
  26. 26. Can you answer these questions? • Describe what is the new expected credit loss model under IFRS 9 • What are the 3 stages of accounting for credit losses and interest income • What are the practical expedients allowed What did you learn?
  27. 27. Answers 1. New credit loss model is forward looking in that now expected credit losses are estimated and recognized before a default or loss 2. In stage 1, losses expected in 12 months are recognized, stage 2 and 3, losses expected lifetime of loan are recognized 3. Practical expedients allowed are information set, low credit risk and past due rebuttable presumption What did you learn?
  28. 28. Faraz Zuberi 2016 Los Angeles, California USA For questions and comments, please write to: Faraz Zuberi farazzuberi@yahoo.com

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