IFRS stands for International Financial Reports Standards which are a set of accounting standards being implemented by financial organisations across more than 110 countries in the world. It covers major countries from Europe, Middle East, Asia, Africa, Oceana, and the Americas (excluding the US). In US, financial organisations are required to follow CECL (Current Expected Credit Loss) method proposed by the US Financial Accounting Standards Board (FASB). Some US based financial entities with dual filing requirements may need to provision based on both IFRS 9 and CECL.
In July 2014, IASB published IFRS 9 which replaced old International Accounting Standards IAS 39 with a unified standard. Financial entities had timelines to implement in the period beginning on or after January 1, 2018.
- Classification and measurement: Under old accounting standard IAS 39, financial asset classification and measurement was based on the financial asset’s characteristics and management's intention in relation to the asset. However as per IFRS-9 accounting standards, financial asset classification and measurement is based on the cash flow characteristics and entity’s business model in relation to the financial assets.
- Impairment: If you are novice in finance and wondering what impairment means, this is the simple definition for you "A loan is called impaired when it is highly likely that bank will be unable to collect the full amount that borrower need to pay in terms of principal and interest." During the financial crisis, IASB realised that the incurred loss model in IAS 39 contributed to the delayed recognition of credit losses. To fix this issue, they introduced a forward-looking expected credit loss model. Under IFRS 9, the expected credit loss (ECL) model will require more timely recognition of credit losses.
- Hedge accounting : The objective of the new hedge accounting model is to provide useful information about risk management activities that an entity undertakes using financial instruments.
As per IFRS 9 there are three stages in which impairment of loan is recognised. They are as follows :
| Stage 1 (Performing) | Stage 2 (Underperforming) | Stage 3 (Credit Impaired) |
|---|---|---|
| Low Credit Risk | Significant deterioration of credit quality. Increase in credit risk since initial recognition (not impaired) | Credit quality deteriorated to a level at which credit loss actually incurs (credit impaired) |
| 12-month expected credit losses | Lifetime expected credit losses | Lifetime expected credit losses |
| Effective interest rate on gross carrying amount | Effective interest rate on gross carrying amount | Effective interest rate on net book value |
IFRS 9 and Credit Risk Models
It is important to go through the above table which shows credit stages prior to reading this section. Based on the credit stages, a loan is categorised into either 12 month Probability of Default (PD) or lifetime PD.- 12-month ECLs (Stage 1): It is applied to all the loans since initial recognition as long as there is low credit risk
- Lifetime ECLs (Stages 2 and 3): It is applied when a significant increase in credit risk has taken place
Question arises how to decide whether a significant increase in credit risk has occured or not.
In IFRS-9, the definition of 'significant increase in credit risk' is not stated clearly. Hence banks need to decide it themselves. There are many ways we can decide credit quality. Some of them are as follows:
- Past History : Loan which has been 30+ or 60+ Days Past Due or defaulted in the past 12 months from the reporting month should be considered a significant deterioration of credit quality and should fall into Stage 2 credit risk.
- Absolute or percentage change between 12 Month PD model at reporting month and 12 month PD model at the time of origination. High value change in the accounts can be considered as 'high risk' accounts.
- Inclusion of Macro economic variables Develop 12 Month PD Model after including macro economic variables such as GDP, Unemployment rate, Interest and Inflation rate, Housing price index etc. and compare the model at reporting month with the model at the time of origination. High absolute or percentage change in the accounts can be considered as 'high risk' accounts.
- Comparison of Year on Year Marginal Probability of Default: Increase in reporting month marginal PD curve as compared to origination marginal PD curve shows increase in credit risk and can be used as a method for identifying high risk accounts.
- Step change in grading scale for corporate loans.
Probability of Default Model from IFRS-9 point of view
Many risk analysts consider Basel 12-month PD model as a starting point for IFRS 9 PD model. But we need to consider factors which are important for building IFRS 9 12-month PD Model.
- Point-in-time (PIT) PD : As per IFRS 9 there should be point-in-time (PIT) PD which means consideration of both current macro-economic factors and risk attributes of borrower. Idea is to incorporate current macro economic conditions while calculating PD. In essence PIT PD moves up as macro-economic conditions deteriorate and moves down as macro-economic conditions improve.
- Best Estimate PD : PD estimates should be unbiased which means exclusion of optimism or conservatism (i.e. downturn) in estimation
- It is required to monitor PDs on a continuous basis and perform recalibration when required. PD monitoring reports are essential.
IFRS 9, CECL and Basel
- IFRS 9 is accounting and financial reporting standards published by IASB.
- It's a global standards for accounting, used by all the major countries except US.
- CECL is accounting standards published by FASB.
- It's used in United States.
Similarities between IFRS 9 and CECL
Both IFRS 9 and CECL were designed with the goal of establishing accounting and financial reporting standards. Both are forward-looking taking the most latest available data of macro economic indicators and borrowers' attributes to forecast losses from default.BASEL vs IFRS 9 and CECL
IFRS 9 and CECL focuses on how banks set provisions (money set aside) to cover expected losses from defaults. Whereas BASEL covers both expected and unexpected losses.Most banks subject to IFRS 9 and CECL are also subject to Basel norms.
| IFRS 9 | CECL | BASEL | |
|---|---|---|---|
| PD | 12 month PD (Stage 1) Lifetime PD (Stage 2 and 3) |
Lifetime PD | 12 months |
| PD | Point-in-time PD | Point-in-time PD | Through the cycle |
| LGD/EAD | Best Estimate | Best Estimate | Downturn Estimate |
Deepanshu founded ListenData with a simple objective - Make analytics easy to understand and follow. He has over 10 years of experience in data science. During his tenure, he worked with global clients in various domains like Banking, Insurance, Private Equity, Telecom and HR.
Will be fantastic if we have a credit portfolio example in excel sheet....
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