IFRS 9 Bulletin
A report from the Financial Services Faculty on IFRS 9
IFRS 9 began on 1 January 2018. Lots of questions are being asked now around volatility, (in)consistency, comparability, assumptions, disclosures, pro-cyclicality and whether the P&L or capital impact is more important.
While IFRS 9 has several parts (including Classification & Measurement and Hedge accounting) to it, the focus mainly has consistently been on expected credit losses (ECL) provisioning.
The impact of classification and measurement should not be underestimated. In one case the increase in provisions was more than offset by the reclassification and newer measures. The bank’s capital strength actually increased as a result of IFRS 9 implementation.
Purpose of IFRS 9 – IAASB views
One of the main aims of the new standard is to use forward looking information more effectively. The provision numbers seen during the financial crisis were backward looking, reflecting the accounting standard at the time – incurred loss. While taking a forward looking approach and using expected loss is a well-established concept within bank regulation (relating to the determination of a banks’ capital requirements), ultimately there is a crucial difference between regulatory and accounting expected loss. The purpose of accounting numbers is to provide an accurate reflection of the financial state of an entity. While expected losses for prudential regulation ensure that enough is put away in the good times so in bad times banks don’t have to raise fresh capital.
The IASB’s original intentions with IFRS 9 was to better reflect the business model of the entity as well as internal management and data practices. This means users should expect some cyclicality in the numbers.
One of the aims was to eliminate some of “odd” outcomes (through “tainting”, changes in business model and inclusion of own credit) that the old standard exhibited. For example, we saw under the old standard that paradoxically a bank would appear more profitable if its credit worthiness worsened. This would occur as the cost of debt it had issued would be priced lower by markets. This would have the effect of reducing the bank’s liabilities (as they could buy this debt back at the lower market price).
It is very difficult to foresee what the overall IFRS 9 numbers will look like once the standard is implemented as banks don’t want to be the first to make significant decisions or to appear as an outlier.
Over time better disclosures should aid understanding; they are a trade-off for judgement required from management and meant to help understanding.
The IASB expects that tripartite discussions between the regulator, banks and auditors should help achieve more consistency in the near future.
Business impact of IFRS 9
IFRS 9 is expected to have a considerable impact on banks’ business decisions, including product development.
Commercial departments will have to support the same RoE on a bigger capital basis as more capital is needed to support the same lending book due to the impact of larger credit provisions. The focus going forward will therefore be on balance sheet optimisation.
Although actual write-offs and credit losses are theoretically unchanged between IAS 39 and IFRS 9, and only their timing is brought forward, there will be significant business effects.
Pricing will be more complicated as the impact of increased income volatility and regulatory stress capital will have to be included in the models.
Both of these will be driven by the increase in Stage 2 assets (where lifetime provision have to be taken, an increase from the 12 month provision needed for Stage 1 assets) and the intensity of losses due to the decrease in the value of collateral.
Investors will have to look out for whether banks’ modelling assumptions are consistent with the market view. They will also have to keep in mind that IFRS 9 implementation is happening in a very benign environment. Therefore the Day 1 impact might not be as significant as originally expected – those banks with the smallest Day 1 impact will likely have the greater income volatility going forward.
One of the main challenges the systematically important lenders face in the UK are the disclosures that will be required to comply with the new standard. Although a variety of approaches will be followed by banks (and other financial institutions), materiality and relevance are the guiding principles.
There are a range of options available for publishing mandatory transition figures all with their respective pros and cons. Some banks will be issuing a separate transition document shortly following the 2017 Annual Report. This document will allow some flexibility in the format and enable banks to help investors understand the change from IAS 39 to IFRS 9. It will help clarify the initial impact of IFRS 9, allow comparisons and provide additional information to explain the opening position, stage allocation, changes by product/business and any simplification applied.
However when comparing between different financial institutions, several other factors will have to be considered. For example, write-offs are interpreted in different ways around the world; ‘relative credit risk’ means something else for each bank so you may see an absolute credit risk measure too. Perhaps Stage 3 (credit impaired) assets will be more comparable.
It is also worth noting that a single factor sensitivity analysis is potentially dangerous - factors in real life are interconnected and change together. Scenario analysis is therefore probably more useful.
It was again stressed how important disclosures are especially considering that a lot of the users of accounts are not accountants themselves. The current approach of investors and analysts to value firms is unlikely to change. A “through the cycle” view of credit losses will still be more relevant for equity valuations. The focus will not be on the volatility of ECL although as a consequence of the earnings volatility, cost of equity will also increase (it is fair to say that we are starting from a very low level of credit loss charges now; any stress would immediately move credit from Stage 1 to Stage 2).
Higher P&L provision charges will probably mean lower dividends when we move to a more adverse scenario.
The effect on regulatory capital is very important and it is unclear at this stage how regulators will adjust for the impact of high expected vs incurred losses in their stress testing and required capital buffers. The impact on regulatory capital is important as it drives a bank’s ability to distribute profits.
Misalignment between the regulatory and accounting concepts of expected loss and the difference between standardised and IRB approaches will make assessing the regulatory capital impacts particularly difficult. Transitional arrangements are there to help banks ease into fully applying IFRS 9. However, when valuing equity, analysts will more likely be looking at the fully loaded capital impact as opposed to the transitional arrangements. This is partly because they are just too complicated.
A helpful addition to the information available, the extended audit report should help clarify management’s prudence, or not in making judgements.
One of the consequences of the new standard analysts see is that some European banks might be using the Day 1 credit losses to get rid of bad losses.
Auditing IFRS 9
Auditing IFRS 9 will not be easy either.
The Global Public Policy Committee (GPPC) has prepared two papers. The first one to help guide banks (The implementation of IFRS 9 impairment requirements by banks) and the second one to assist audit committees – The auditor’s response to risks of material misstatement arising from IFRS 9.
Based on the fundamental concepts, the importance of the accounting policies, procedures and internal controls is emphasised.
Banks will have to have robust governance over information systems as the volume of information processing to generate ECL estimates and related disclosures are expected to require a heavy reliance on information systems and controls.
It is essential that the audit committees continue to challenge the reliability, transparency and usefulness of disclosures to the users of the financial statements.