The full implementation of International Financial Reporting Standard 9 (IFRS 9) continues to settle across businesses, more so with early adopters.
Implementation is settling down..
However, the challenges remain broad, and largely underestimated. IFRS 9 brought both quantitative and qualitative impact on organisations, particularly so with credit extension enterprises. Beyond the quantifiable P&L and capital reserve implications, the Expected Credit Loss (ECL) regime that IFRS introduced has far reaching implications on business strategy, product constructs, regulatory compliance and credit origination, to say the least.
The impact is much broader
Let us start with the obvious; the impact on reported bottom line, which is from two angles really. One is the volatility, increased costs is yet the other. ECL provisioning is forward looking, numerous variables and highly technical assumptions come into play, and the result is what can be best described as a fair value, which only becomes as good as the judgement at the point of modelling.
On the other hand, IFRS 9 causes more financial assets to be measured at “fair value through profit & loss”, any changes in fair value are recognised in the P&L as and when they arise. Unlike with an ‘incurred loss’ loss provisioning model, as was the case under the erstwhile International Accounting Standard 39 (IAS 39), the ECL model is forward looking, incorporating potentially volatile expected losses of a loan asset throughout its lifetime.
The expected losses themselves are a product of a wide range of outcomes weighted by probability of occurrence.
This, in short means that a single loan asset will likely have a fluctuating fair value throughout its life, not withstanding that the loan will be fully collected by end of its tenure.
Significant fluctuations in reported bottom line can have far reaching consequences; investor confidence can be eroded, credit downgrades may follow (may be less of a problem for most of Botswana entities), regulatory reserves can be threatened, and other factors. Such volatility needs to be managed, and doing so can be a headache.
A proactive approach is necessary, and this is where the real business impact of IFRS 9 gets broader; credit decisioning needs to take into consideration loan life expected losses, loss reserve thresholds adjusted for, capital buffers revised (upwards) and all these, in all probability will point towards pricing and construction of credit products.
Pricing and product appeal often carry a competitiveness implication, and as such, how a business models its ECL can have a direct bearing on its market competitiveness.
The second angle is a more direct one, magnitude of which, however, is often underestimated. IFRS 39 introduced a totally different ball game with respect to processes, people and systems, and these cost money to upscale (upskill in case of people).
Setting up models and systems cost money (lots of it). Deciding on model parameters and inputs entails lots of technical assumptions (and commensurate, often pricy skills), same goes for model construction, its ongoing validation and refinement, independent assurance work etc.
Subsidiaries and branches of larger multi-nationals often feel the burden less as they can call up on specialised central resources, unfortunately, the same benefit is often unavailable for local corporates.
An additional angle for regulated banks
There are some pronounced implications on regulatory capital for Banks. Let’s begin with some context. Regulated Banks face capital supervisory under the Basel framework, which is essentially a non- prescriptive set of capital and liquidity standards that the Basel Committee on Banking Supervision came up with.
The Basel Framework itself has evolved over time, with Banks in advanced economies currently grappling with practical implications of Basel IV. However, Banks in countries such as Botswana are (and for right reasons) still regulated under Basel II accord.
Capital Adequacy is a key theme under the Basel framework, and credit risk is a prominent feature thereof. The Basel Committee allows regulated Banks a choice between two approaches for calculating Capital Requirement for Credit Risk; the Standardised Approach and the Internal Ratings Based Approach.
A bank adopting the second option
There are two broad categories of Capital, being Tier 1 and Tier 2. Tier 1 is broadly made up of Common Equity Tier 1 (CET1) and Additional Tier 1 (AT1). CET 1 is the component of major interest for regulators and it is made up of share capital and retained earnings, but also subject to some regulatory adjustments.
Retained earnings accumulate (or deteriorate) over time as a function of annual profit after tax as well as dividends declared and paid. And there lies the direct link to IFRS 9.
We have appreciated the volatility implications of ECL to reported profits after tax, and this volatility is carried through to CET 1, arguably the most important component of total capital. Remember, under IFRS 9, credit losses are staged in three tiers;
Stage 1: Assets are performing well, with no indications of significant credit deterioration, no loss event, but entities are required to estimate and account for expected losses for the next 12 months.
Stage 2: Assets are performing, but with indications of significant credit deterioration, however no loss event has occurred, but entities are required to estimate expected losses over the entire life of affected assets.
Stage 3: There has been significant credit deterioration, and a loss event has actually occurred. Entities are required to estimate credit losses over the entire life of the affected assets. At this point, interest income recognised against the affected assets is net of recognised ECL.
From the above, one can clearly see that under IFRS 9 (unlike IAS 39), ECL provisions are not only volatile but generally higher; entities take provisions on performing assets, with no indications of significant credit deterioration (stage 1), entities book life time expected losses on the basis of a broader spectrum of indications, even before those crystalise into a loss even (stage 2) and these are over and above what would ordinarily have attracted IAS 39 provisions (Stage 3).
A further point to consider is that a lot more assets are now eligible for ECL provisioning than before, and this include undrawn down commitments on credit facilities, (yes! based on assessed customer behaviour).
What is the practical implication of all this for capital management? Wider buffers- and increased costs. One thing is certain- entities can no longer be comfortable at the same capital buffer levels they operated prior to January 1, 2018.
When entities adopted IFRS 9 for the firs time, extant exposures were subject to ECL provisioning, in most (if not all) cases resulting in an additional charge against reserves (“The Day 1 impact”).
This reduced the most sensitive component of regulatory capital, CET 1. This had an immediate impact on Capital buffers. However, for regulatory reporting purposes (and not for financial reporting), some jurisdictions allowed for a phased approach with which the Day 1 Impact will be amortised over a period of time, say 3-5 years.
As a side point, Banks with AT1 instruments on their balance sheets have a secondary buffer as such instruments automatically converts to qualify for CET 1, subject to certain triggers, if that class of capital falls below regulatory thresholds.
Implementation of IFRS 9 potentially comes with increased costs, increased credit impairment stocks, which are highly volatile in nature. Increased costs eat on profits, volatility impairs investor confidence and credit rating if not well managed (or at least well explained).
Businesses strategies cannot ignore the impact- product constructs and pricing are affected, as well as credit protection mechanisms.
It is not business as usual for banks either- capital buffers need to be fatter, and dividend policies could need adjustments or potentially face a balking supervisor if declarations are deemed too generous for sustained capital buffers.
*Dr Mbako Mbo is Standard Chartered Bank Botswana’s Chief Financial Officer