Implementation of International Financial Reporting Standard 9 (IFRS 9) on January 1, 2018 will mark a sea change in centuries-old accounting conventions, and will force banks to dramatically increase provisioning against loans that are at risk of turning sour.
The regime and its US analogue, the Current Expected Credit Loss (CECL) rule, usher in a shift to expected credit loss (ECL) accounting in favour of the current incurred losses approach – in which a loan is recorded as healthy on a bank’s books up until the point of impairment. Under IFRS 9, dealers will be required to calculate ECL for all loans over a 12-month period, and over the entire lifetimes of loans that have deteriorated in credit quality.
For some banks, the jump in loan-loss provisioning under the regime could be as much as 30% versus current levels according to some estimates – potentially forcing banks to divert retained earnings or dip into their own capital buffers. The result could be a hit to Common Equity Tier 1 capital of up to 45 basis points, according to one study.
IFRS 9 buckets loans into three stages – stage 1 for healthy loans, stage 2 for underperforming loans and stage 3 for impaired loans. Where a loan’s probability of default (PD) rises between reporting periods, banks must increase provisioning accordingly. Banks fear that, should a sudden sustained economic downturn affecting multiple sectors occur between reporting dates, they may be forced to downgrade loans by a stage en masse, with the attendant steep rise in provisioning potentially leading to capital shocks.
As Nimesh Verma, director in bank advisory, corporate and institutional banking at BNP Paribas, notes: “IFRS 9 significantly increases volatility and procyclicality. It amplifies provision levels and drives large shifts in regulatory capital on an ongoing basis, as changes in economic outlook mean swaths of assets move between stages 1 and 2.”
Some lenders aren’t waiting for a downturn in macroeconomic conditions to dictate matters for them – several are already considering pre-emptively downgrading loan books that are most at risk of a rise in PD by shifting them into the next bucket down, effectively front-loading any resultant capital hit and helping smooth profit and loss volatility.
Regulators are also cognisant of the risks incurred if banks under their watch suffer hits to their capital and earnings, and have made efforts to phase the rules in more slowly as a result. Recent moves by the Basel Committee on Banking Supervision to give local regulators more latitude in this regard have also been welcomed by the industry.
The other main cost for banks in complying with the rules has been a significant retooling of loan-loss modelling capabilities to accommodate the shift to the ECL regime. This is where some banks have looked to lighten their load by repurposing existing credit risk capital models to provide the point-in-time estimates required under IFRS 9, where losses are calculated across fixed time horizons – either one year or over the lifetime of the loan. In this sense, banks that have opted to use the Basel II internal ratings-based approach for calculating credit risk capital requirements will be at an early advantage.