The introduction of the new accounting standard on Impairments (IFRS 9) on 1st January 2018 was intended to correct the failings of the previous standard, IAS 39, which was deemed to have been partly complicit in exacerbating the financial crisis of 2008.
The perceived problem, with the previous standard IAS 39, was that it appeared to have a restricted view on how to report bad loans. It was designed to only look at loans that had already been impaired at the Balance Sheet date. It was a simplistic approach but easy to understand. However, it was not forward-looking, readers of the Balance Sheet were not guided towards the pipeline of loans that that had the potential to be impaired in the coming months past the balance sheet date.
The new accounting standard, IFRS 9, tried to solve this predicament of not reporting on the pipeline of potential loans that may be impaired past the Balance Sheet date. The solution was two-fold.
Staging
The first was to introduce staging with the main intention being to identify loans that are showing signs of significant distress, even though they have not been impaired, and giving them an impairment value.
This category of loans would be classified as Stage 2 which would lie between Stage 1 for loans that are showing little or no signs of distress and Stage 3 for loans that have already become impaired.
Scenarios
The second key amendment that came about through IFRS 9 was to introduce the concept of a forward-look which in practice meant that Banks were now required to predict how the loan book would behave, in terms of staging, across future multiple scenarios with each chosen scenario being given a particular weighting.
Banks have discretion to choose the scenarios and the weighting. This was designed to give the real post-balance sheet date outlook.
Modelling
Most banks introduced modelling to try and estimate the staging calculations across a range of scenarios. So, whilst IAS 39 was too simplistic, the introduction of modelling techniques within IFRS 9 made the understanding of the key drivers and sensitivities impacting the overall IFRS 9 impairment value more difficult for the Board, bank senior management as well as the reader of the financial statements.Bank Disclosures
In fact, when one reviews the last set of audited bank accounts from December 2019, the disclosures focus very much on information on the type, and weight, of scenarios used, and the spread of the loan book across the three stages - and not the underlying factors that impact the staging.
This limited information makes it hard for the reader of the accounts to judge if the impairment value is reasonable – they see only the outputs of the ‘black box’ and not the inputs to the model or the model’s structure. Moreover, the ability of each bank to choose its own scenarios and weights means comparability is also compromised.
Back to Basics
The time has therefore come to revisit the basics and strike a balance between the simplicity of IAS 39 and the complexity of IFRS 9.
Put simply, basic credit information such as arrears and forbearance which are timely indicators of whether a loan is in distress should be given more prominence in the disclosure notes. Their impact on the impairment calculation should be highlighted before the effects of modelling for scenarios.
This is an important step to “regain control” of the understanding of the basics of the overall impairment value. In due course banks may wish to review their provision coverage ratios. Does it make sense to have very low provision coverage for assets that are technically in arrears or being forborne? Such disclosure would also help to mitigate the lack of comparability and give the users a deeper understanding of respective credit risk profiles.
In the world of Covid-19, with increased uncertainty in predicting the potential impairment value, partly because economic scenario predictions are even more volatile, banks will have to understand how customers might behave once their payment holiday has been lifted. In particular, Banks and their governing bodies must be able to demonstrate that they have an understanding and line of sight of how these payment holidays avoid falling into arrears or forbearance arrangements. Without this understanding banks will continue to be reliant on their models which were quite clearly not designed to forecast a Covid-19 pandemic.
For example, these models, constructed in 2018 did not anticipate that the hospitality and aviation sectors would be particularly vulnerable in a 2020 pandemic scenario. Consequently, a lot of banks have had to rely on model overlays to form a view on their Covid-19 impairment calculations.
Model overlays and adjustments have now become the ‘norm’ and not the exception. Not surprisingly this has only made the understanding of the IFRS 9 impairment value opaquer to the bank Audit Committee and Board. A return to basics with disclosures to demonstrate the impact of raw credit information on arrears, forbearance and payment holidays on IFRS 9 may lift some of the fog and bring back some of the simplicity of understanding that readers of the financial statements miss.