Now that we are nearing D-Day, and panic has started to set in, we wonder if some of you are tempted to buy familiar named solutions for IFRS 9 and pay too much for what you get. Not only would you expose yourselves to unexpected Expected Credit Losses, you also end up paying far too much for solutions that do not actually help you calculate or survive the tsunami.  

Background – just in case you missed it

For those of you who need more background on the topic, I refer you to our previous articles on this very popular subject:

1. Are you ready for IFRS 9 impact on Credit Risk? http://goo.gl/hdsZHj
2. The impact of IFRS 9 on Credit Risk – part 2 http://goo.gl/ZO8gBd
3. The pitfalls of applying IFRS 9 in Credit Risk http://goo.gl/MDJdVK
4. IFRS 9 and the 64 x Credit Risk https://goo.gl/quqrtM

This is the latest on IFRS 9 which is designed to help you avoid falling in the usual IT traps. I have taken the liberty of sharing with you correspondence with a bank that is just about to start its IFRS 9 assessment. “IFRS 9 is not only an accounting change, it touches every area of the bank. It is essentially a tsunami, that will, in our opinion force banks to merge with half the banks disappearing within 5 years of its implementation, across the globe. Let me to tell you why:

Timing and Provisions

• You are required to take provisions on every account (NPL and good accounts) on the first day of business, irrespective whether the client defaulted or not. First day of providing a “letter of offer” to the client that is. Since it is the first day, this provision is taken on Authorized Limits.
• This provision is taken immediately in the bank’s Income Statement, for all to see.
• The amount of provision you take depends very much on how you estimate your Probability of Default (PDs). Some banks use debt rating systems to assess default (such as Moody’s and S&P), and validate these systems with actual incidents of default. IFRS 9 is not about debt, it is about cash flows and whether the client is unlikely (in future) to generate sufficient cash flow to cover its bank obligations (the stuff we teach in the CRM). So the bank needs to validate the ratings they use today using a cash centric system (such as 6 Sigma’s CRS).

How PDs are Measured

• To give a more practical idea of the difference between a debt rating system and a cash flow centric system, we already identified in the last CRM course 3 accounts that fall in the “default” category and hence their ratings would be much higher than the bank expects. These were supposed to be “good” clients.
• The focus of banks today is to identify those that are likely to default or have a high probably of not being able to generate sufficient cash flow to cover bank obligations, as early as possible so that they can do something about them (and there are two things you can do to sort them out). Given that IFRS 9 kicks in on 1.1.2018, then this exercise should have been done 11 months ago. If not, the sooner the better.
• If the bank were not to identify potential defaulters early, then it exposes itself to a 30 days’ backstop rule. Under IFRS 9, if the client did not settle overdues within 30 days, then he is classified Stage 2. This means that the provisions you take on him increase from 3% to 12%. If this client were to also have a term loan averaging 5 years and charged around 7%, then the 3% increases to 48%. That’s almost half of the loan amount! Imagine this across the whole portfolio….

The Solution?

• Here’s the catch, by the time a client defaults or goes over 30 days, then the bank’s ability to do anything about it diminished greatly. In the past there was a possibility of passing on the problem to another bank. With all banks being extra careful under IFRS 9, this option is no longer available.
• In addition, many institutions claim to have calculators for IFRS 9. With our discussion with major auditing firms, central banks and other bankers, we are confident that the solutions being sold in the market lack considerably on two fronts: calculating the right figures, and being inadequate to help you manage the portfolio to survive the tsunami. The issues that they seldom address include:
  1. Calculation of Probability of Default at 90 / 30 / 0 days default. How do you do it and whether the definition of default is appropriate.
  2. Definition of “Significant” Deterioration of Credit Risk. With a cash flow system, you can easily do this. With a debt rating system, it is very difficult.
  3. Are we dealing with ORRs, FRRs, STORRs, TMORR, or PRRs?
  4. Calculating Effective Interest Rate (including fees etc), how it is done.
  5. Which Facilities are IFRS 9 applicable? Using appropriate Credit Conversion Factors.
  6. Which Collateral is IFRS 9 applicable? This is still being debated.
  7. What is a suitable Collateral Volatility %? This is not even considered.
  8. What is a suitable Collateral Expected Period of Liquidation? You need to support this with studies. So where do you start?
  9. Is there a Right of Offset over Collateral across Facilities? That is not even considered.
  10. Double counting collateral: Netting Exposures whilst using LGDs
  11. NPVing PDs and LGDs – double NPV
  12. Capturing Outstandings when they exceed Limits
  13. ECLs can be larger than exposures for some Lifetime cases.
• Your head of risk mentioned in a meeting that the bank already subscribed to the vendor’s IFRS 9 module. He also confirmed that the bank is in the process to validate its PDs, and hopefully will be ready to get results by March 2017, in anticipation for disclosure by June 2017 as per Central Bank directives. I did not want to debate the issue with him as that was not the forum for it. However, I have a few points to raise:
  1. To start off with, March 2017 is too late. We offered the bank to do this within a 24 hours’ period, and we are still waiting for word.
  2. All my respects to your vendor, however the bank has paid an arm and a leg to get a module that would have cost it 10% of what it is actually worth, and one that is not even cash flow centric in its estimates.
  3. In all cases the bank needs to validate its ratings with a cash flow centric module, lest you have accounts not captured in your process leaving the bank exposed to provisions of 48% of limits.

There are many other issues the bank needs to address to manage the onslaught, not least a new policies and procedures manual that caters for all the requirements, and a total change in the way the bank captures business. I urge you to look into this. I will be happy to provide the seniors with a presentation on the topic. The last time I did to a Saudi bank I had quite a few raised eyebrows.”

For those that use our CRS, next steps are:

Please speak with your 6 Sigma Account Officer to help you achieve this.

What if I do not have CRS?

If you are still using other systems but want to make use of our PRR and IFRS 9 modules, please contact us on ramzi.watfa@6sigmagrp.com. We will eventually need from you:

1. A list of obligors with some data on each
2. A list of their facilities with specific data on each
3. Your PD table so that we can map it to ours (or use ours)
4. A list of your Facility codes and their descriptions
5. A list of your Collateral Security codes and their descriptions, along with their average period to Liquidation, and their Volatility in Value (if known).

The rest is easy. An IFRS 9 estimate of your provisions can then be calculated using a cash centric system within 24 hours… © 2016 6 Sigma Group While the information contained herein is believed to be accurate, neither 6 Sigma nor any of its affiliates or subsidiaries or its employees makes any representation or warranty, express or implied, as to the accuracy or completeness of the information set out in this document or that it will remain unchanged after the date of issue of this document, and accordingly neither 6 Sigma nor any of their respective affiliates or subsidiaries or employees has any responsibility for such information. This document is not intended by 6 Sigma to provide the sole basis of any credit decision or other evaluation and should not be considered as a recommendation by 6 Sigma that any recipient of this document should purchase an equity stake in, provide credit facilities to, or conduct any business with any company(ies) listed in this document. Each recipient should determine its interest in the information provided herein upon such independent investigations as it deems necessary and appropriate for such purpose without reliance upon 6 Sigma. WANT TO USE THIS ARTICLE IN YOUR NEWSLETTER OR WEB SITE? You can, as long as you include this complete phrase with it: “6 Sigma Group teaches bankers around the world how to become better bankers. Get the “5 Mistakes Bankers Do in Credit Analysis” at www.credit-risk-store.com”