IFRS 9 Loan Impairment – Implications for
Regulation and Supervision
Meeting of the Group of International Financial Centre
Supervisors
28 April 2015, London
Raihan Zamil
Financial Stability Institute
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Agenda
 Context
 Key Components of IFRS 9 Expected Loss Model
 Supervisory Implications
 Regulatory Policy Implications
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Background
“ (We) call on the accounting standard setters to work
urgently with supervisors and regulators to improve
standards on valuation and provisioning and achieve a
single set of high-quality global accounting standards”
G-20 Summit Leader’s Statement
2 April 2009
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Current Situation - Fragmented Approach
Type
Methodology
Time Horizon
IAS 39
Provisioning
• Incurred loss approach – requires loss event trigger
• Recognised through income statement
• Too little, too late; procyclical
• Incurred, lifetime losses
at reporting date
• Future events cannot
be considered
Basel II/III – SA
Provisioning
• Relevant for all non-IRB banks
• Uses IAS 39 provisioning figures reported in P&L
• Some countries require regulatory provisioning rules – based on
combination of supervisory classification (‘normal’ – ‘loss’), collateral
recognition, and prescribed loss ranges
• If supervisory provisioning > IAS 39 provisioning difference
deducted from CET 1
• General reserves included in T2 capital (up to 1.25% of RWA)
• Incurred, lifetime losses
• Lifetime expected
losses implicit in local
supervisory guidance?
Basel II – IRB
Provisioning
• Relevant only for IRB approved banks
• Main purpose to derive unexpected loss (UL) for capital under IRB
approach
• If 12 month EL > IAS 39 provisions, difference deducted from CET 1
• If IAS 39 provisions> 12 month EL, surplus counted as T2 capital (up
to .6% RWA)
• Incurred losses lifetime
losses
• 12 month expected
losses
• Cycle neutral PD
• Downturn LGD
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Implications for Application of Basel Capital Rules
 Reliability and consistency of (Basel II/III) regulatory capital ratios
heavily dependent on accuracy of loan loss provisions
 Comparability across banks and jurisdictions a major challenge
 Adherence to accounting concept of provisioning DOES NOT necessarily
imply that provisions are ‘adequate’ from a supervisory perspective
 Provisioning more art than science and requires expert judgment
 Small decline in asset values = disproportionate decrease in capital ratios
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Key Elements of IFRS 9
Expected Loss Provisioning
Model
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Overview of IFRS 9 Expected Loss Model
Stage 1
Stage 2
Stage 3
•
Upon credit origination,
12 month expected credit
losses (EL) established
and recognised in P&L
• If credit risk of loan increases
significantly and the resulting
credit quality is not considered to
be low credit risk, lifetime EL are
recognised in P&L
• 30 day rebuttable presumption
•
•
12 month EL= 12 month
PD x lifetime LGD
• Lifetime EL = lifetime PD x
lifetime LGD
• Lifetime EL = lifetime PD x
lifetime LGD
•
Analagous to performing
loans
• Analagous to ‘underperforming’
loans but not yet impaired
• Analagous to ‘non-performing’;
and current incurred loss
model under IAS 39
•
Interest income
recognised on gross
basis
• Interest income recognised on
gross basis
• Interest income recognised on
net basis (net of provisions)
•
Credit impaired or incurred
loss has occurred
Similar to IAS 39 impairment
model
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Practical Expedient for Financial Assets with Low
Credit Risk
 If credit risk of financial instrument is low at reporting date, bank
can measure impairment using 12 month ECL – does NOT have to
assess if significant increase in credit risk has occurred
 To apply this operational simplification, all of the following
requirements must be met
 instrument has low default risk
 borrower is considered in the short-term to have strong capacity to
meet its obligation; and
 lender expects, in the longer-term, that adverse changes in economic
conditions might, but will not necessarily, reduce ability of borrower to
fulfil obligation
 cannot consider collateral in determining if credit risk low
 Main intent: to provide relief to FIs that hold large portfolios of
securities with high credit ratings
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Stage 2 Loans: Assessing Significant Increase in
Credit Risk
 Focuses on change in probability of default occuring
(repayment capacity of borrrower) not change in expected loss
 Compare with PD at initial recognition to determine if change
in PD ‘significant’ – depends on starting point
 Cannot rely solely on past due status if supportable forward-
looking information available at undue cost
 Generally, a financial instrument would have a significant
increase in credit risk before there is objective evidence of
impairment or before default occurs
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Modified (Restructured) Loans
 If contractual cash flows on financial asset renegotiated or
modified (but financial asset is not derecognised) – financial
asset not automatically considered to have lower credit risk at
time of modification
 An entity should assess if significant increase in credit risk since
initial recognition based on all available historical and forwardlooking information – including circumstances that led to
modification
 Evidence that lifetime EL on modified loans no longer required
include:
 Timely payments on modified terms over a period of time
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Treatment of Collateral
 In measuring EL (12 month or lifetime) – expected cash
shortfalls should reflect cash flows expected from collateral
 Estimate should reflect amount and timing of net proceeds
from sale of collateral, less costs of foreclosure and cost to sell
(regardless of whether foreclosure is probable or not)
 Key input into LGD calculation
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Implementation Timeline and Transitional
Arrangements
 IFRS 9 becomes effective 1 January 2018, with early adoption
permitted
 Standard to be applied retrospectively
 Year of initial application: make one-time adjustment to
retained earnings (component of CET 1) to reflect changes in
amount of provisions held under IFRS 9
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Supervisory Challenges
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Stage 1 and Stage 2 Loans – Supervisory Concerns
 Stage 1 – Provisioning based on 12 month EL
 may not capture various sources of credit risk that occur beyond
12 months – but inherent in loan terms at time of origination
 may overuse application of ‘low credit risk’ practical expedient to
avoid lifetime EL calculation
 Stage 2 – lifetime EL if significant increase in credit risk since initial
recognition
 Wide scope for interpreting ‘significant increase’ in credit risk inconsistent application likely given same set of facts
 Will FI’s fall back on 30 day past-due practical expedient?
 Will there be a ‘cliff effect’ if FI’s wait too late for lifetime loss
recognition?
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Stage 3 (Impaired ) Loans
 Not a new requirement (same as IAS 39) – but implementation
a persistent problem
 Lessons from financial crisis and recent reports of audit quality
of SIFIs and G-SIBs suggest major shortcomings in auditors
review of provisions under IAS 39
 “For audits of SIFIs and G-SIBs, the..inspection themes with
the highest number of findings..were..audit of the allowance
for loan losses and loan impairments”
International Forum of Independent Audit Regulators, April 2014
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Revenue Recognition on Impaired Loans
 Interest income recognition on stage 3 category (and possibly
stage 2) loans has potential to overstate net interest margins,
earnings and regulatory capital
 Appropriateness of income recognition premised on
management ability to accurately project timing and amount of
recovery of net carrying amount of impaired assets
 Some jurisdictions apply prudential measures to mitigate
supervisory concerns
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Policy Implications
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What are links between GFICS’ member countries
prudential standards on provisioning and IFRS 9?
 Performed desktop review of three GFICS countries prudential standards
on classification and provisioning – some high level observations
 “Pass’, “SM’, ‘Substandard’, ‘Doubtful’, ‘Loss’ typical classification
categories used
 Asset classification definitions broadly similar across countries
reviewed, but important differences exist
 Minimum provisions applied to each classification category varies by
country – recognition of collateral for purposes of provisioning varies
- Pass & Special Mention- typically no provisions required ( 1 country requires 5% on
SM)
- Substandard: 10-25%
- Doubtful: 50-75%
- Loss: 100%
 Placement of non-performing loans on nonaccrual status varies
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Mapping of IFRS 9 Provisions to Regulatory Asset
Classification Practices in 3 GFICS Jurisdictions –
(Conceptual Example Only)
Regulatory
Asset
Classification
‘Pass’
IFRS 9
Stage 1
IAS 39
Unimpaired
Special
Mention
Substandard
Doubtful
Stage 2
Loss
Stage 3
Impaired
Impaired
Stage 3
Stage
2
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Example - Minimum Regulatory Provisioning Requirements vs.
IFRS 9 Provisioning

Minimum Regulatory Requirements

IFRS 9 Provisioning (stage 3 loan)
(assume Substandard classification)
Example: Commercial real estate loan past due
over 100 days and internally classified
Substandard. Repayment now expected solely
from liquidation of physical collateral (assume
commercial building)
Current Book Value
100
Original Interest rate
9%
Physical collateral
100
Physical collateral after HC
@ 70%
70
Amount subject to
provisioning
30 @ 20%
Required provisions
under regulatory
requirements
6
Loan book value
100
Physical collateral
100
Assume foreclosure costs and costs to
sell at 5% of collateral value
5
Estimated Value of physical collateral
less foreclosure costs and costs to sell
95
PV of estimated recovery: (assume
3yrs., discounted at 9%)
73.3
Estimated Impairment loss
26.7
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Questions for Policy for GFICS Jurisdictions
Policy Options
1. Apply (at national discretion) regulatory
provisioning rules as a backstop to IFRS 9?
Considerations
•
•
•
2. If so, what changes are required to asset
classification definitions (‘pass’- loss’) to map
to IFRS 9 EL definitions (stage 1 – stage 3)?
•
•
•
Needed if IFRS 9 is already EL based
model?
Useful backstop to ensure baseline
provisioning?
If used, what minimum provisions required
– per classification category?
Stage 1 is functional equivalent of ‘pass’
loans
Stage 2 loans biggest challenge – could
encompass highest risk ‘pass’ category to
portions of ‘substandard’
Stage 3- Doubtful and Loss and some
Substandard
3. Are changes needed in the calculation
methodology of credit RWAs?
•
•
What constitutes specific reserves under
IFRS 9?
Provisions related to stage 3 only?
4. Should general provisions be allowed to
be included in T2 capital?
•
•
What is a ‘general reserve’ under IFRS 9?
Why include in T2 if losses are expected?
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Conclusion: Judgment Day is Coming
 IFRS 9 significantly expands role of judgment on an evaluation
process (under IAS 39) that is inherently subjective
 Banks - will need to build new models for 12 month EL and
lifetime EL (particularly stage 2 loans)
 Auditors – how to review a more complex provisioning model,
given major problems with high-quality audits of (simpler)
incurred loss model?
 Supervisors- significant capacity building efforts likely to develop
processes and expertise to validate for prudential purposes
 Investors – what do reported numbers mean?
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Key Takeaways
 IFRS 9 EL model arguably most significant accounting rule change this
century – affects all (IFRS reporting) financial institutions in all jurisdictions
 IFRS 9 EL model not countercyclical, but less procyclical than IAS 39
 Difficult to precisely estimate incremental provisions required under IFRS
9..but impact likely to be material
 Basel III capital ratios even more difficult to comparable globally upon
adoption of IFRS 9 without better harmonisation of regulatory provisioning
rules and practices
 The BCBS’ Accounting Experts Group developing supervisory guidance on
provisioning to help support robust implementation – consultative paper
issued in 1Q 2015; final publication expected year-end 2015
 Stakes could not be higher - underfunded provisions undermines integrity of
Basel II/III capital
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The Sacred Troika:
Balance Sheet, Income Statement and Regulatory Capital
Balance
Sheet
Adequacy of the allowance for loan losses?
•
•
Timely loss recognition of impaired and restructured loans?
Timely recognition of expected losses on performing loans?
Prompt recognition of non-accrual loans – interaction with IAS
39 and IFRS 9?
Prompt recognition of all impaired HTM and AFS securities?
Appropriate valuation of foreclosed collateral?
Appropriate valuation of assets subject to MTM, whose
valuations are heavily assumption dependent (trading)?
Earnings
Overstated Asset Values = Overstated Earnings
Capital
Overstated Earnings = Overstated Common Equity
Tier (CET) 1 under Basel III
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Questions?
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Annex: Comparing Asset Classification and Provisioning Rules in 3 GFICS
jurisdictions
GFICS
Member
Pass
Special Mention
Substandard
Doubtful
Loss
Country 1
•
•
Past due >30 but less than 90 days;
or
Exhibits weaknesses, which if not
corrected, weakens the bank’s
position at future date – examples
include deteriorating economic
conditions, adverse trends in
obligor’s financial position, collateral
deteriorating.
•
Past due for more than 90
days but less than 180
Renegotiated debt due to
weaknesses in borrower’s
repayment capacity
Inadequately protected by
paying capacity of obligor
even if not past due yet
•
Past due more
than 180 days but
less than 360
Collection of full
improbable – but
actual amount of
loss not
determinable
•
Loan may be current, but certain
factors could in future affect
borrower’s ability to service debt
Inadequate credit documentation
Past due 1-3 months
Restructured debt paying as agreed
for 1 yr. after restructuring
•
Well-defined weakness –
cash flow insufficient to
service debt; repayment
reliant on collateral
Loans with repayment in
arrears of at least 3 months
•
Collection of debt
questionable
Possibility of loss
Unsecured portion
of loans more than
6 months past due
•
clients are experiencing difficulties
which, if they persisted, could result
in losses
examples include deteriorating
condition of collateral..economic
conditions or adverse trends in
obligor’s financial position
•
definable weaknesses are
evident that could
jeopardize repayment of
interest
assets may or may not be
past due..
assets past due > 30 days
but < 89 days
•
Collection in full is
improbable
Any asset past due
> 90 days but <
180 days unless
well-secured and in
process of
collection
•
Country 2
•
•
•
Country 3
Fully protected by
sound worth and
paying capacity of
borrower
Sound financial
condition of
borrower
Good collateral
and sufficient to
cover exposure
Loans up to 30
days past due
Not defined
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
Past due more
than 360 days
Regardless of
past due status
– asset
considered not
collectible
Uncollectible
loans
Unsecured
portion of loans
past due 12
months
facilities are
considered
uncollectible
very little or
nothing can be
done to recover
outstanding
amount on any
collateral
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