Dear friends, although the migration from IAS 39 to IFRS 9 is intended for better risk management across all the global banks, the change will materially affect bank’s financial statements. In fact, the impairment calculations are expected to be affected the most. The scope of IFRS 9 initially applies to bank institutions in Europe, the Middle East, Africa , and Oceania. Calculating the forward-looking statements based on these new changes may be challenging and will also need a high degree of judgment. Some of the major impacts of IFRS 9 will be on –
- Calculation of Credit losses
- Classification and Measurement
- Hedge Accounting
- Disclosure
Let us now discuss the impacts in more details in the next section.
1. CALCULATION OF CREDIT LOSSES
The credit losses are predicted to increase and become more volatile under the new Expected Credit Loss (ECL) model. The complexity of judgments is also bound to increase.
Potential Impact –
- IFRS 9 introduces the concept of ECL model. This model uses a dual measurement approach and requires recognition of 12 months ECL or calculation of a lifetime of ECL. Assets that did not have a significant increase in credit risk since initial recognition uses the 12 months ECL approach while assets that have witnessed significant deterioration in its credit quality have to follow a lifetime ECL approach.
- Loan impairment is recognized in three stages:
Stage 1 – No significant increase in credit risk since initial recognition
Sage 2 – Significant increase in credit risk since initial recognition
Stage 3 – When the loan is considered credit-impaired, new model increases the level of complexity and judgment assuming that banks will be able to make estimates of ECL and establish when significant changes will occur.
- As discussed above, the new model will require extensive data and complex calculations. This will need an updated internal control mechanism, new systems , and processes. Also, a large amount of data will be required in each case to check if there has been an increase or decrease in the credit risk as compared to what was predicted.
Illustration 1: Now, let us look at the calculation of expected credit loss below in order to understand the concept better.
| Particulars | Value |
| Expected cash flows (A) | $1,000 |
| Expected cash flows if a default occurs (B) | $250 |
| Cash shortfall (C = A – B) | $750 |
| Default probability (D) | 1.5% |
| Expected credit loss (E = C * D) | $11.25 |
2. CLASSIFICATION AND MEASUREMENT
Classifications of financial assets have become more prone to judgments and also have an impact on how capital resources are calculated.
Potential Impact –
- The method in which bank classifies the assets sets the method for calculating capital resources and capital requirements. This leads to volatility in the calculation of profit or loss on equity.
- Classification and measurement may also have an influence on product features and product processes. For example, product features in loan contracts and processes like loan underwriting and securities buying may be impacted.
- According to IFRS 9, the calculation of financial asset is based on contractual cash flow characteristics and the business model for managing the asset. A significant amount of judgments is required in determining this calculation.
The below table sets the reclassification from IAS 39 to IFRS 9 –
| Classification under IAS 39 | Classification under IFRS 9 |
| Fair value through profit or loss (FVTPL) (Held for trading) | FVTPL (Residual) |
| Loans and receivables | FVTPL (Residual) |
| Amortised cost | |
| Fair value through other comprehensive income (FVOCI) for debt | |
| Held to maturity | Amortised cost |
| Available for sale (Residual) | FVTPL (Residual) |
| FVOCI for debt | |
| FVOCI for equities |
3. HEDGE ACCOUNTING
Changes in hedge accounting are made which is now more closely related to risk management. This is also applicable for a broad range of hedging strategy.
- The new hedging model developed by IFRS 9 for banks is closely related to risk management. Although this model requires additional hedging strategies, it also puts restrictions on a few of the current hedging strategies.
- This new model is mostly based on principles and more assumptions are required in re-balancing, qualifying and discontinuing hedge accounting.
- This can be done by first determining which strategies are in line with current risk management objectives and whether the current method provides sufficient link between both the hedging styles.
Illustration 2: Let us take the example where Company A with its local currency (LC) has forecasted sales in a foreign currency (FC) worth 2 million in a span of six months. Assume that there will not be any significant change in the fair value of assets. Determine how will the IFRS 9 testing criteria be met in this case?
Under IFRS 9, the testing criteria can be passed if it meets the critical terms. The critical term , in this case, forecast sales and terms of the derivative being used will be like –
- Quantity – FC2 million
- Underlying risk – FC/LC exchange rate
- Timing – Settlement date matches the timing of sales in FC
4. DISCLOSURE
Significant additions have been made under the disclosure segment. Internal revamp in system and controls will also be necessary to capture the changes in the required data.
Potential Impact –
- Since a lot of assumptions will now be required in making decisions, qualitative data or disclosures explaining how these assumptions are made will also be necessary. Also, quantitative disclosures regarding financial assets will be required.
- New disclosures regarding impairment are also mandatory. Sourcing this information will be complex and time-consuming.
- Additional disclosures for hedge accounting are required.
- These changes or updates in the disclosures have to be done by assessing the current systems and identifying the data gaps that are to be filled to meet the additional requirements.
Now, there are broadly two types of disclosures – Qualitative and Quantitative
The Qualitative disclosures include:
- Inputs, assumptions , and techniques which are used to determine expected credit loss, determine credit-impaired assets
- Write off policy and assumptions
The Quantitative disclosures include:
- Reconciliation data
- Carrying amount per credit risk
- Write off amount, recovery and modification
Now, let us also look at the impact IFRS 9 will have on impairment, regulatory capital , and stakeholders.
IMPACT ON IMPAIRMENT
There are mainly three drivers which lead to an increase in impairment –
- As discussed in the first point, banks have to provide ECL for a lifetime for entities that have witnessed a significant decline in creditworthiness but has not currently incurred a loss.
- IFRS 9 now requires banks to recognize the losses for future undrawn commitments.
- Banks require to calculate a probability-based estimate against various economic scenarios making impairment calculations more conservative.
Illustration 3: Let us look at an example to understand this well. Assume that a lender gives out $100,000 in loan and the rate of interest is 5% (includes risk premium of 2%). Both interest and principal are paid at maturity. The total cash flow that will be received is $110,250. Under the traditional approach, the total interest that would be received is $5,000 in year 1 and $5,250 in year 2. However, in the new method, this excludes the risk premium that is demanded by the lender against the risk of default. As such the rate will be 3% and the total interest will be $3,000 in year 1 and $3,090 in year 2. The difference of $4,160 in the total is allocated an impairment allowance.
| Traditional method | New method | |
| Value of loan | $100,000 | $100,000 |
| Total interest income | $10,250 | $6,090 |
| Impairment allowance | – | $4,160 |
| Total cash flow | $110,250 | $110,250 |
IMPACT ON REGULATORY CAPITAL
Regulatory capital is mainly driven by common equity and profits, and this has a component of impairment charges. Increase in impairment is basically a drag down on the capital. However, the impact is determined based on the bank’s risk profile, regulatory permissions, accounting policies as well as economic conditions.
IMPACT ON STAKEHOLDERS
There has been an increase in capital buffers for many lenders especially the ones with high systemic risk. Banks which fail to meet this criterion ill face restrictions on dividend payments and in payments of debt coupons. This change will also have an impact on staff payments and pension benefits. IFRS 9 will make it difficult for banks to make these payments and maintain buffers.
CONCLUSION
In order to incorporate these changes, banks should prepare a fair assessment of potential IFRS 9 impact and put this in numbers in the form of capital adequacy where required. Banks should also allocate resources to have IFRS 9 implemented, conduct proper stress testing and explore synergies. However, this change to IFRS 9 may be useful to the lenders since most of the models will now be loss-making for all the big and the small banks. Due to the change, lenders will realize higher synergies between the three important factors – impairment, capital adequacy , and stress testing.Read more: IFRS COURSE: ALL YOU NEED TO KNOW ABOUT IFRS DIPLOMA CERTIFICATION
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