Let us call a spade a spade, IFRS 9 is here to stay and it will force all banks to change into the IRB world. This is NOT about calculations, it is a Way of Life; a notion that accountants and non-bank consultant will never be able to grasp. For non-IRB compliant banks, the world of banking will change dramatically over the next 18 months. First off, this initiative is not driven by Central banks, and hence you will find limited support from that end. Second, you will have to shift your financial analysis from a traditional debt based ratio and EBITDA models to a forward looking cash-flow centric approach. Third, the impact on your current business practice will be profound.
We have just completed and are in the process of launching our IFRS 9 Module. In our opinion, and even if we say so ourselves, this is one of the most comprehensive and well designed modules that tackles IFRS 9 from all its aspects. It takes into account not only the issues that have already been addressed by the accounting fraternity, but also all the other aspects of capturing and reporting Expected Losses (ELs) that have not been identified or tackled thoroughly (as expressed publically or privately) by anyone outside 6 Sigma.
Calculation Compared with what is normally practiced under Basel’s Economic Capital, the main differences in accounting for ELs under IFRS 9 are:
- The need to NPV ELs versus actual year end calculations under Economic Capital
- The summation of future ELs (Lifetime) in case of Significant changes to credit risk; versus 12 months for all Economic Considerations.
The NPVs are not new to banking. They have been used to calculate Loss Given Defaults (LGDs) for over 30 years, and are recognized as adequate for accounting and economic purposes. Similarly the multiplication of ELs once Significant Credit risk is experienced is also not that new, as the Probability of Default (PD) curve swings exponentially past a certain threshold.
What is significantly different now:
1. The accountants who know very little of credit risk are setting the rules. Accountants by nature are reactive monitors of events, they record events after the fact not before (IAS 39). The fact that they (and non bank consultants) are now expected to opine on potential future events, they are forced to use mathematical modeling techniques to assess ELs which under-estimate Loss Norm tables, and have led many a bank to lose big sums or experience missed opportunities.
2. The majority of banks who have so far sheltered under Basel’s Standardized mode of operation are now forced to switch very quickly into IRB. This is not so bad by itself as it is about time that bankers behaved as bankers and not brokers of currency. However it is leaving them in the dark in terms of how to manage the transition.
In the process, there are many issues that have not been identified in calculating ELs under IFRS 9. This notion is also shared by some Central Banks who voiced unease with (a) the use of certain non-cash flow centric risk rating systems to predict default, and (b) that accountants will ultimately resort to the simple 30 days backstop rule to capture defaults, rather than the predictive methodologies called for under the Basel accords.
We thought we would share with you some of the issues that arose whilst we were developing our IFRS 9 module to raise your level of awareness, and help you judge the appropriate methodology to use in calculating your ELs:
- Default before fact and at most 30 days. In the IFRS 9 document, rescheduling is considered a default (Stage 2). However the trick is to recognize the need for rescheduling BEFORE you have to do it; and you can only do so using cash flow centric credit analysis.
- Definition of “Significant” deterioration of Credit Risk. If you were to use a cash centric risk rating system with a scale of 1-10, this is simply the cross over from a risk rating of 6 to a 7. Otherwise you will create a fast universe of completely useless triggers to measure this deterioration.
- Which rating to use: ORRs, FRRs, STORRs, TMORR, or PRRs? According to the accounting fraternity, the assessment is on ORRs only, with exposure amounts adjusted for collateral. This by itself is extremely short sighted as it does not take into account facility specific characteristics, the affects of target market and risk acceptance criteria, stress testing, the cumulative portfolio characteristics, as well as the exponential rise in the PD curve. As an example a risk rated 6 obligor would carry an EL of 3%, whilst one of his cash collateralized facility (FRR 1) should carry an EL of 0%. The fact that the collateral is subtracted from the exposure before applying the EL does not (a) account for weighted average of exposure across the whole portfolio, and (b) does not account for Right of Offset conditions across all facilities for that obligor.
- Which Facilities are IFRS 9 applicable? Some countries are assessing IFRS 9 impact using CCFed exposures whilst others full exposures including off balance sheet items.
- Which Collateral is IFRS 9 applicable? The verdict on which collateral is permissible is still out, for good reasons. Receivables and Inventory can be used under certain jurisdictions whilst not in others. As such, the distinction in collateral within different countries is a must.
- What is a suitable Collateral Volatility % and Expected Period of Liquidation? Again by country and supported by studies based on mark to market assessments.
- Calculating Effective Interest Rate (including fees etc), has to account for amortized fee structure.
- ECLs can be larger than exposures for some Lifetime cases. In some cases where the repayment schedules are stretched, the NPVed ELs can be higher than the original facility limits and a capping mechanism is needed to check on this condition.
- In many banks across the MEA region, and I am sure across many other countries as well, actual outstandings are higher than reported limits. This is due in part to allowing line managers to approve variation in utilization (mostly up to 10%) to allow for transactional daily excesses, and in some parts simply due to lack of controls. In all cases, the outstandings should be used in calculating ELs not limits, and as a result banks will experience wild volatility in provisions.
As you can see, not all IFRS 9 calculators will be the same, and you have to be careful which one to use.
Complementary to current CRS Functions
Our CRS was designed long before the onset of IFRS 9 as a cash flow centric risk assessment model. This was based on best in class methodologies and in line with the Basel accords. As such the ability to report IFRS 9 ELs is not much different from what the CRS was designed to capture in the first place. The new IFRS 9 module captures all the aspects listed above plus much more.
In our previous articles, we detailed what we regarded to be the most important points raised in the Basel and IFRS 9 documentation, their potential impact on the banks and the steps we believe that banks need to take before the onset of the deadline. These can be read on:
- IFRS 9 and the 64 x Credit Risk
- The Pitfalls of Applying IFRS 9 in Credit Risk
- How do TMRACs work in Credit Risk?
- The impact of IFRS 9 on Credit Risk – part 2
- Are you ready for IFRS 9 impact on Credit Risk?
What is really important post the introduction of IFRS 9 assessment, is how banks are going to live within an IRB and IFRS 9 environment. They would have to manage the following 9 issues on an ongoing basis:
- Calculate Portfolio Risk Rating (PRR)
- Stress Test the Portfolio
- Establish targets for PRR and Return on Economic Capital.
- Identify ways to increase Revenue to Expense Ratio
- Produce Product Programs
- Produce Industry Studies
- Produce Target Market Studies
- Structure Facilities Appropriately
- Allocate appropriate SOW% and Tenor per obligor
Which are in line with the Basel accords. However to help them they will require support from dedicated systems, and well-versed consultants.
So where do you go from here?
Given that you have less than 18 months left to go before you have to go live with IFRS 9 you will need to:
1. Identify which accounts are most vulnerable and be prepared to take the proper provisions:
- You have to capture provisions for accounts overdue beyond 30 days (not 90 days as under IAS 39)
- If it is a term loan and is rated Watchlist or worse, then the provision is over 16 times the normal
- The provisions are on Limits and not Utilization and reported in the Income Statement. However, where utilization is higher than limits (as seems to be evident with most banks), then you must account for Utilization instead.
- You have to account for government exposure ELs
2. Either restructure, change facility offerings, or exit 3. Abide by all of Basel’s guidelines for Managing Credit Risk 4. Upgrade your financial analysis system to a forward looking cash flow centric program 5. Implement the proper credit risk processes, which include forward looking cash flow evaluation, TM/RACs and regular and consistent portfolio monitoring and stress-testing.
The 6 Sigma team has been working with both commercial and central banks over the past several years and we are in a position to provide you with both the advice and support you need to not only get ready for the introduction of IFRS 9 but more importantly, live within it. All of our team members are long-serving ex-bankers from the industry’s top names with significant hands-on experience in risk, credit, portfolio, operations and marketing.
Our industry leading CRS will provide you with all of the information needed by the CEO, CRO and CFO to be fully IFRS 9 compliant. CRS will enable you to identify:
- which accounts are most affected,
- how much are the provisions on each account and by portfolio,
- whether your portfolio is able to withstand the cost
- how to strengthen your portfolio
- which industry studies you should produce
- what product programs you should use
- what facility limits should you offer each of your clients to manage the overall portfolio risk and ECLs under IFRS 9.
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© 2016 6 Sigma Group
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