EBA: small banks will be worst hit by IFRS 9

Standard approach banks disadvantaged by higher capital impact and implementation burden

Heavy blow: standardised approach banks expected to be more affected

New accounting requirements that require provisioning for expected losses on credit exposures will result in higher provisioning and profit-and-loss (P&L) volatility, along with a decrease in banks' capital ratios, particularly for smaller banks using less sophisticated credit risk modelling, according to a report from the European Banking Authority (EBA).

The new IFRS 9 accounting standards, requiring banks to provision against expected credit losses, are slated to replace the existing framework in 2018.

According to an EBA study released on November 10, the new rules will increase provisions by as much as 30% and could cut Common Equity Tier 1 (CET1) ratios by as much as 75 basis points – with banks using the standardised approach (SA) for credit risk capital suffering the most.

"Looking at current levels of CET1, standardised approach banks could be more impacted, also because their calculation of own funds is different from internal ratings-based (IRB) approach banks. However, it is not easy to categorise all banks, because there are a lot of different factors influencing outcomes at the same time," says Delphine Reymondon, head of the capital and asset-liability management unit at the EBA in London.

The biggest change under IFRS 9 is new impairment requirements, requiring banks to provision for credit losses from the moment a financial instrument is originated or purchased, rather than the current approach under IAS 39 where losses are not recognised until there is evidence that financial assets have become impaired. Banks must provision for 12-month expected credit losses on financial assets for so-called Stage 1 assets with lower credit risk; when there is an increase in credit risk, an asset is classified as Stage 2 or 3, and provisions have to be made to cover expected credit losses for the full lifetime of the asset.

The shock is for the second-tier banks that are currently on a standardised approach and it will be particularly tough for banks that do things like consumer credit
Ian Tyler, Alvarez & Marsal

Banks using the IRB approach for calculating regulatory capital held against credit risk already use an expected loss approach and can obtain relief by using 'provision miss', where they compare expected losses over a 12-month period with the corresponding accounting provisions. If the accounting provisions are larger than their expected losses, they can recognise the difference in Tier 2 capital for up to 0.6% of their credit risk-weighted assets. Banks using the SA cannot take advantage of that relief.

"The shock is for the second-tier banks that are currently on a standardised approach and it will be particularly tough for banks that do things like consumer credit. A bank that issues a lot of consumer credit cards and personal loans will be hit hard, as the expected loss on credit cards and personal loans is quite high. So a move to IFRS 9 will generate quite a big additional provision that actually will be a deduction from their capital resources," says Ian Tyler, a managing director at consulting firm Alvarez & Marsal in London.

The quantitative part of the EBA study – based on 'best effort' estimations as of December 2015 from a sample of 47 banks – found provisioning requirements increased by 18% under IFRS 9 on average, and up to 30% for 86% of respondents. CET1 and total capital ratios decreased on average by 59bp and 45bp, respectively, and by up to 75bp for 79% of respondents.

Killer volatility

"A 59bp average and one percentage point for outliers is not far off from what I had expected. Portfolios have improved and provisioning has increased over recent periods. The impact is likely to have diminished since the EBA data request," says Adrian Docherty, global head of financial institutions advisory at BNP Paribas in London. "However, it's the volatility that will be the real killer."

Indeed, in the survey, 67% of banks said they expect IFRS 9 impairment requirements to increase P&L volatility. They said it was mainly because of the cliff effect caused by assets being moved from Stage 1 to Stage 2 buckets due to increasing credit risk. And 62% of banks do not anticipate volatility will have a significant impact on an ongoing basis in the classification and measurement of financial instruments under IFRS 9, compared with IAS 39.

The EBA also expressed concern that banks were behind in implementing the new standard. According to the survey's qualitative section, which had a sample of 58 banks, none are yet in the testing phase of IFRS 9, and more than 50% are still in the design phase for classification, measurement and impairment. And 14 of 18 smaller banks, compared with 11 of 40 larger banks, are in the early design stage.

Most banks are still in a design phase of IFRS 9. Smaller banks are less advanced than larger banks in terms of preparation
Delphine Reymondon, European Banking Authority

With time running short, being behind in implementation also means that while most banks conduct parallel runs of IAS 39 and IFRS 9 before application of IFRS 9, the duration and scope of runs will be smaller.

"Most banks are still in a design phase of IFRS 9. Smaller banks are less advanced than larger banks in terms of preparation, and parallel runs will be shorter than originally envisaged, which is another area of concern for us. A source of concern for the banks is the availability and quality of the data, as well as the potential lack of resources for implementing IFRS 9, which is a complex standard," says the EBA's Reymondon.

Standardised approach banks are again at something of a disadvantage because they do not have systems in place yet to calculate expected loss, in contrast with IRB banks. However, the IFRS 9 expected loss modelling requirements will still be an implementation challenge for IRB banks, because of differences such as the use of point-in-time probability-of-default (PD) numbers for IFRS 9, compared with the through-the-cycle PD used under IRB.

The EBA will soon launch a second impact exercise as banks get further along with IFRS 9 implementation. The results of the studies will be used to inform upcoming work and decisions on IFRS 9. For example, discussions are ongoing at the Basel and European level regarding the treatment of loan loss provisions in regulatory capital under the SA, and whether there should be a transitional phase for implementation of IFRS 9.