Credit Impairment in IFRS 9: Challenges and Solutions

A paper on the new impairment model and the the main impacts.

Context

The “old” accounting standard IAS 39 (introduced in 2005) has proved fragile in the face of the great financial crisis of 2007-2009. The idea that future profit margins would be enough to cover the intrinsic risk of “healthy” credit exposures, unless an unexpected, traumatic event were to occur (“incurred loss”), has left its mark on the banks’ balance sheets, a “cliff effect” that has led to highly procyclical shifts, that were not adequately covered through early provisions.

As regards credit exposures, the new IFRS 9 represents a breakthrough, in an attempt to deal with the banks’ loan books in more balanced and insightful way. On the one hand, prudential provisioning is now required even for fully performing loans, albeit limited to the coverage of default risk only for the subsequent year. On the other hand, an intermediate level between performing and non-performing loans has been introduced, to account for those exposures that, although not still in a full-blown distress, show a marked increase in risk compared to initial conditions (meaning that the spread originally agreed with the debtor is no longer enough to offset future expected losses). A more realistic system is, inevitably, a more complex system.

Impacts

Adapting the investment and loan portfolio to the new three-stage impairment model requires the development of new risk metrics, their calibration/validation based on data that are as extensive and robust as possible, and uniform and strict application to the whole credit population. All this must be achieved by taking profit from risk parameters that banks already estimate and use (typically, for credit risk management purposes), aiming for maximum consistency and minimum duplication of effort. Moving from words to facts will prove an exciting – still complex - challenge.

Furthermore, moving from the old to the new system will trigger a huge change compared to current measurements. This will impact the banks’ profit and loss account – above all in the first year of application - and capital levels. Managing the changeover in a context where institutions are requested to increase and retain capital (also to avoid constraints on dividend distribution) will prove the most sensitive phase from a technical point of view, and paradoxically the one that banks will face – by definition – while still unexperienced with the new standard.

As is always the case, decisions must be driven by knowledge. It is a long road, but this paper is a small, important step in the right direction.

Index of the Paper

  • The new impairment model
  • A preview of the main impacts
  • Recognizing risk: first time adoption and transfer criteria
  • Measuring lifetime expected loss
  • Forward looking assessments
  • How IFRS 9 will affect processes
  • A possible work plan

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