Sir David Tweedie
Chairman
International Accounting Standards Board
30 Cannon Street
London
EC4M 6XH
1 September 2009
Dear Sir David,
Request for Information (‘Expected Loss Model’) Impairment of Financial Assets: Expected
Cash Flow Approach
This is the British Bankers’ Association’s response to the above request for comment. We welcome
the opportunity to provide our views at a relatively early stage in the Board’s deliberations on this
subject.
We recognise that the IASB began this project to fulfil the G20 Leaders’ request for accounting
standard setters to ‘strengthen accounting recognition of loan-loss provisions by incorporating a
broader range of credit information’. In our view, it is important to differentiate this project (and the
G20 request) from projects being conducted by the Basel Committee and others, also at the request
of the G20, to address pro-cyclicality. These latter projects are designed to build up counter cyclical
capital buffers to absorb losses which may arise over the economic cycle as opposed to the life of an
existing asset.
Whilst we support the IASB project to consider how expected losses could be incorporated within the
financial reporting framework and understand the banking regulators’ desire to address procyclicality, it is vitally important that measures introduced by banking regulators to build up counter
cyclical capital buffers do not undermine general purpose financial reporting as required by IFRS. As
such, we fundamentally disagree with the notion held by some that additional regulatory capital
buffers required by prudential regulators should be recorded in the Income Statement and impact
profit and loss. In our view, IAS 1 disclosures of capital are the correct way of providing information
to investors about capital requirements, including counter cyclical buffers.
That being said, although we support the idea of ensuring that provisions raised incorporate a
broader range of credit information than may currently be the case, we do not agree with the
expected cash flow approach as set out by the IASB for both conceptual and practical reasons.
The approach results in the smoothing of the recognition of losses by deferring interest that has
actually been received to cover losses that are expected to occur in the future. In the unlikely event
of losses occurring exactly as expected, the net income would be recognised evenly and the
financial statements would include no information about actual losses. When expectations about
future losses change, an adjustment would be required and, assuming the adjustment relating to
credit losses could be separated from adjustments relating to changes in expectations about other
factors, for example prepayments, the meaning and information content of the adjustment is unclear.
Users seem better served by information about losses that have occurred rather than information
that the original expectation of losses have changed. Disclosure of such losses in addition to this
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approach would be an added complication and suggests that the basic accounting is deficient. In
summary, the approach seems to reduce the transparency of financial reporting and does not seem
consistent with its objectives.
The presentation of the results of the approach is not set out in the papers. However, it is clear that
there would be changes to the way interest is recognised and that loan loss allowances would either
not exist or would represent only changes in assumptions since origination rather than allowances
for the whole amount of the current expectation of losses. Since key performance indicators for
banks are interest margins and loan loss allowance coverage ratios and the approach will
fundamentally change or remove this information from the financial statements, we do not consider
that it would be an improvement to financial reporting.
Information about expected losses over the entire lives of loans is not generally currently available.
There is little available data about life time probabilities of default and the approach seems likely to
introduce very much more judgement and subjectivity than is currently the case. This seems likely to
result in less consistency between entities.
There are also extensive practical problems with the proposals. There would be challenges in
developing reliable models to calculate and calibrate lifetime PDs and the resulting losses in order to
determine the expected losses that would be used to reduce effective interest income. In general
and particularly for new products, new business and new markets, there would be little historic data
to support such long term, forward looking assumptions. There would be considerable challenges in
developing a process to modify the contractual balance and interest data from source systems to
defer interest. An approach along the lines currently adopted for EIR could be adapted to spread the
expected losses, although the challenges would be significantly greater than for the existing EIR
model as a result of the need for continually assessing expected future cash flows for all loans and
portfolios as well as expected lives and prepayment rates. The greater amounts that would
essentially be held off balance sheet and spread into income to approximate recognising interest
based on the effective interest rate lead to significant control and reconciliation challenges.
Most of the costs that arose from banks’ initial IFRS implementation related to EIR, impairments and
hedging. These proposals result in significant changes in at least two of these areas. Therefore, we
estimate that the cost of implementing the Expected Cash Flow model would be significant and
would be in the region of 50 to 75 per cent of the cost of first time adoption of IFRS for reasonably
large and complex financial institutions. On this basis, we estimate the implementation cost across
the largest UK institutions would be between £150 million and £225 million or an average of £25
million to £37.5 million per institution. In addition to this we believe that the on going cost would be
significant.
Therefore, since the approach does not appear to result in an improvement in financial reporting and
has considerable costs, it seems clear to us that it must fail any reasonable cost/benefit test. We are
therefore of the view that the Board should focus on developing a less complex approach to
impairment. The IASB’s time in this area would be better spent examining areas where the existing
requirements were thought to result in impairment losses that existed at the balance sheet date not
being recognised and amending the existing requirements as necessary to help ensure that proper
application of the standard would not prevent such losses being recognised. This may help improve
consistency of application and support appropriate recognition of losses. There is also a need for the
Board to provide clearer guidance in certain areas, particularly to guide management in the types of
data which should be used in making assessments of future economic conditions.
We set out our detailed comments below.
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1. Is the approach defined clearly? If not, what additional guidance is needed, and why?
As the expected loss model discussed is by its nature forward looking, entities will be required to
factor expectations about future economic conditions into their calculations of expected future cash
flows. Whilst we acknowledge that historical data will inform assumptions about future cash flows to
a significant degree, management will be required to assess data and projections of future economic
circumstances so as to enable them to adjust their expectations accordingly. This will be extremely
complex and will require the application of significant judgement, and while it may be helpful if the
Board was to provide non-exhaustive examples of the types of data sources which should be used
by management to inform their decision making, it will be very difficult for the Board to provide
sufficient guidance to ensure consistency across different entities given the vast diversity of business
activities, systems, market conditions and economic environments. For example, we believe that the
proposals will create particular problems in their application to revolving credit instruments such as
credit cards and overdrafts and that further guidance will therefore be required.
It will also be necessary for the standard to better articulate the principles underlying the expected
loss assumptions, for example are they based on conditions at a point in time or through an
economic cycle and, if through an economic cycle how should the cycle be determined. We agree
that disclosure will be necessary to inform users of the data sources and key assumptions used by
management in making their judgement.
2. Is the approach operational (i.e. capable of being applied without undue cost)? Why or
why not? If not, how would you make it operational?
We anticipate that the expected loss model would be very challenging to implement both technically
and in terms of the resources which will be required. Particular issues to overcome are likely to
include the lack of historical loss data for some classes of financial instrument (particularly for
specialised assets in new or emerging markets), the need to extend existing control processes to
track the disaggregated credit spread from initiation and the increased complexity of the EIR which
will require, unlike at present, expectations of credit losses to be reassessed continually.
It will also be necessary to make an assumption that losses arise evenly over the expected loan
lives. While there are challenges around determining the quantum of expected losses, it seems
impossible for entities to have expectations of the timing of the missing cash flows over the lives of
the loans. In theory, the timing of the missing cash flows could be material to the calculation of the
original effective interest rate but in practice, it will be necessary to make a standard assumption
about timing in the absence of better information about future events.
Assumptions will also need to be made to address the variable rate issue.
In addition, there are likely to be difficulties in transition. Full retrospective application would require
judgements to be made about expected losses in the past which may involve unacceptable hind
sight. Full prospective application would require loans to be accounted for in different ways
depending on when they were originated and this difference could persist for a long time.
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3. What magnitude of costs would you incur to apply this approach, both for initial
implementation and on an ongoing basis? What is the likely extent of system and other
procedural changes that would be required to implement the approach as specified? If
proposals are made, what is the required lead time to implement such an approach?
We estimate that the cost of implementing this approach would be in the region of 50 to 75 per cent
of the cost of first time adoption of IFRS for a reasonably large financial institution. On this basis, we
estimate the implementation cost across the largest UK institutions would be between £150 and
£225 million or an average of £25 to £37.5 million per institution. In addition to this we believe that
the on going cost would be very considerable given the need to operate separate systems and
processes for expected cash flow impairment and the expected loss methodology under Basel II.
We believe that the financial institutions would need a significant lead time to implement the
proposals. Not only are they hugely complex to implement in themselves but they will come at a time
when institutions are also implementing the standard which replaces IAS 39. We suggest that an
implementation date of financial periods beginning on or after 1 January 2012 would be appropriate
if the final requirements are available two years before the implementation date.
4. How would you apply the approach to variable rate instruments, and why? See the
Appendix for a discussion of alternative ways in which an entity might apply the expected
cash flow approach to variable rate instruments.
The Appendix sets out two proposed approaches to the amortisation of upfront costs and two for the
impairment of variable rate instruments. In terms of the former, Approach A (the amortisation of
upfront costs using the original EIR calculated at initial recognition) is most in keeping with our
understanding of how most organisations have implemented EIR.
In terms of the later, impairment of variable rate instruments, the most practical way of implementing
the proposed approach would be to build on existing practice. This would be most consistent with
approach B (keeping the effective interest rate constant after impairment and treating changes in the
carrying amount resulting from changes in the variable benchmark rate as ‘catch-up’). However,
under this approach a relatively small change in cash flows due to an impairment could have a
significant impact on income recognition due to the additional impact of changes in variable interest
rates, which does not seem correct. Approach A may therefore be more conceptually sound,
however approach B may be easier to implement. Given the systems complexities it may be
preferable for the Board not to mandate a particular method.
5. How would you apply the approach if a portfolio of financial assets was previously
assessed for impairment on a collective basis and subsequently a loss is identified on
specific assets within that portfolio? In particular, do you believe:
(a) Changing from a collective to an individual assessment should be required? If so,
why and how would you affect that change?
(b) A collective approach should continue to be used for those assets (for which
losses have been identified)? Why or why not?
We believe that the final standard should be flexible in these circumstances and would argue that an
entity should adopt an approach which fits with the way in which it manages under performing
assets. In our view, an entity should therefore remove the under performing sub set of assets from
the portfolio if its continued inclusion if that is its normal business practice or if continued inclusion
undermines the continued management of the portfolio as a whole. We believe the Board should
therefore focus on drafting a principle which permits entities to determine the most suitable but
avoids losses being double counted.
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6. What simplifications to the approach should be considered to address implementation
issues? What issues would your suggested simplifications address, and how would they
be consistent with, or approximate to, the expected cash flow model as described?
We believe that an approach should be adopted based on calculating expected loss at a portfolio
level. This would not only provide a simpler model to implement, but arguably would provide a better
representation of expected loss since the loss by its very nature is not attributable to individual
assets.
Yours sincerely,
Paul Chisnall
Executive Director
Direct Line: 020 7216 8865
E-mail: paul.chisnall@bba.org.uk
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