Ben Guy, technical consultant for regulatory practice at 4most Europe, examines the implications of IFRS 9 and looks at what is likely to come after it.

IFRS 9 is the new accounting standard from the International Accounting Standards Board (IASB) issued back in July 2014. It replaces the current standard ‘IAS 39’ for implementation before 1 January 2018, bringing with it three distinct changes.

Impairment models need to be “forward looking” and based on expected credit losses (ECL), with the allocation of loans to impairment stages being based on increases in credit risk.

Changes to the requirements around classification and measurement, depending on how assets are managed and their contractual cash flow characteristics.

Changes which are intended to simplify the general requirements for hedge accounting and create closer links to risk management.

Without going into detail on the second and third points above, the key concerns are (1) how financial instruments are categorised and accounted for on a company’s balance sheet and (2) how to value hedged positions and the approach to risk management for hedge accounting.

The first point however, has a significant impact across a wide range of financial institutions and this is worth discussing so that we can better understand the impacts and challenges ahead.

Under IAS 39, models can be backward looking. Whether it is calculating the estimated loss on an impaired or paying account, both tend to use historic information to try and infer how that represents current losses.

What we already know

IFRS 9 makes a number of changes to the current standard, such as:

Models have to be forward looking. This means organisations can’t just use past performance to predict future performance. It also requires the incorporation of macroeconomics like the unemployment rate or the house price index.

Loans need to be allocated to one of three stages and movement between these stages needs to be based on changes in risk.

Lastly, and depending on the level of risk, the ECL will have to represent the potential loss over the “lifetime” of the agreement. This is referred to as the lifetime expected loss (LEL).

The challenge of predicting change

The first point is a technically challenging one. Organisations may be able to tweak what is already in place elsewhere, for example internal ratings-based (IRB) capital models, or they may require the development of new models.

Either way the use of macroeconomic scenarios will be vital in meeting the requirement, but predicting these can be challenging, particularly during times where there is uncertainty in the market or a fairly benign period of history.

Brexit was a huge surprise, and this has increased the challenge of predicting how things might change in the future. The level of uncertainty will decrease over time but in January 2018 we are unlikely to fully understand the implications of the UK leaving the EU on crucial macroeconomic drivers like unemployment or the housing market.

The second point covers the allocation of loans to stages. Stage one applies to all loans as long as there is no significant deterioration in credit quality. Stage two applies where there has been a significant deterioration in credit quality but the account is not yet impaired, and stage three applies to accounts that are impaired.

The term “significant” can be interpreted in different ways, and that’s the challenge. The assessment of what is considered significant should be based on multiple factors, but this will differ across products and organisations.

The financial implications of IFRS 9

The third point is a big one in terms of the monetary cost of IFRS 9. The change from 12mEL to lifetime expected loss (LEL) brings significantly increased provisions. In addition, accounts in stage three will also require interest revenue to be based on the effective interest rate (EIR) at net carrying amount.

Most organisations are working hard to develop a compliant solution for IFRS 9, and the solution implemented will be heavily scrutinised by the regulators. It is absolutely crucial that models are deemed suitable and are meeting the requirements before 1 January 2018.

Organisations also need to understand the impact of all of this. There are direct impacts to profit and loss (P&L) because of the increased provisions and changes to interest income, but there are also indirect impacts to consider which could be financial or operational.

Financial impacts could be seen with improved pricing strategies or through the use of forbearance or debt sale activity. Operational impacts will likely occur as potential improvements to collection strategies are identified, or from the increased requirements for monitoring and validating the new models, which will likely be more sophisticated than what is used today.

Organisations then need to parallel run their new models and compare them against what is in place now. The longer the parallel runs can go on for, the more insight achieved and this will (1) help to prepare for the costs and (2) help to understand some of the indirect impacts mentioned above.

More to come

After IFRS 9 is done there is still plenty to come. For example, the consultancy paper from the Prudential Regulatory Authority ‘CP29/16’ will result in some significant changes to how organisations calculate the probability of a customer defaulting on their residential mortgage, and to how they estimate the expected loss during a time where the economy is “stressed”.

It could also be as a result of something like Brexit because the regulation is part of EU legislation, the Capital Requirements Directive (CRD). This is a legal framework based on a voluntary one, Basel III. Basel III sets out the rules on capital measurement and capital standards. If, or rather when the UK leaves the EU, the Bank of England (BoE) / PRA will most likely need to define a version of Basel III that will fall under British law. If the BoE and regulators interpret elements of Basel III differently to CRD, this could translate to new requirements for how banks measure and hold capital and how they provision for expected losses.