How realistic is the impairment charge estimated by banks? This is the prime question in the minds of regulators and accounting bodies when the actual losses posted by banks far exceed the estimated impairment charges in their books. To prevent such instances, the International Accounting Standards Board (IASB) replaced IAS 39 with a new standard IFRS 9 in July 2014. In effect, there is now a paradigm shift in accounting for impairment from the Incurred Loss model under IAS 39 to the Expected Credit Loss (ECL) model as per IFRS 9. Under the Incurred Loss model in IAS 39, credit losses are not recognized until such an event has occurred, whereas the forward-looking ECL model preempts such losses. The effective date of compliance with IFRS 9 is January 1, 2018, though most organizations are contemplating an early adoption.
What is the impact on banks and financial institutions?
Here are some key changes that IFRS 9 will introduce:
- More sophisticated measurement of credit losses: Methodologies to measure credit losses vary across organizations. Credit losses depend on various factors such as obligors financial indicators, future projections for the industry and segment, and current credit ratings. This compels banks to build business models that include statistical techniques required to estimate credit losses, which may be either deterministic or stochastic.
- Inclusion of key market indicators: Banks will need to consider additional data like external credit rating, credit spreads, current and forward interest rates, and so on.
- Integration with asset liability management (ALM) system: The impairment accounting system will need to align with the ALM system for reuse and adjustment of future cash flows of instruments to accurately calculate expected credit losses.
- Alignment of risk and finance streams: In the traditional approach, only the finance division of a bank had a play in the computation of impairment charges since the underlying driver was incurred loss, but now, with expected loss being the driver, both finance and risk divisions need to align better and work closely. Forecasting credit losses means risk assessment of obligors, which falls under the risk domain. This necessitates tight collaboration between the two functions to ensure the provisions estimated as per IFRS 9 and the expected loss model are in sync.
These aspects will have considerable impact on functional and IT architectures, business processes pertaining to impairment management, and interactions between the risk and finance systems in an organization. Financial firms therefore need to evaluate the impact and devise a change management strategy to ensure timely compliance with IFRS 9.
How to achieve IFRS 9 compliance?
In essence, IFRS 9 results introduces changes in the following areas:
- Classification of financial instruments
- Definition of business models for estimating credit losses and mapping them to obligors
- Execution of business models to compute the ECL and validating business models by comparing actual credit losses against ECLs
- Generation of reports on provisions (with the breakdown of new charges, write-back, recovery, and write-off)
In light of these changes, banks should look at:
- Capturing details on attributes like interest rate frequency, fixed or floating nature of interest rate, benchmark rate, credit rating grade and agency in financial instruments; demographic data of retail obligors; financial metrics of corporate obligors; and macro-economic and idiosyncratic variables that are required by analytical models to estimate credit losses
- Enhancing the existing data source systems to allow for the capture of additional information
- Developing business models for different portfolios (retail, commercial, and corporate)
- Creating interfaces between source systems and market data feeders for market variables like yield curve, currency rates, and so on
- Developing and managing models, right from defining model objectives to validating them
- Establishing transparency in the entire process for demonstration to regulators
The immediate priority for banks is to conduct a gap analysis and evaluate how existing systems can be improved to meet the IFRS 9 requirements. While an advanced technology solution will allow financial firms to deploy an integrated platform to automate the entire impairment accounting process flow in a flexible and transparent manner, organizations would also need to redefine business models, realign risk and finance business processes, and configure business models on analytics solutions. Choosing the right solution would depend on the nature and size of the firm, and the adaptability of technology solutions to the evolving regulatory guidelines within stipulated timeframes.