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IFRS 9: Regulatory capital

The implementation of new reporting standard IFRS 9 from 1 January 2018 is a key priority for the banking industry. In July 2017, ICAEW's Financial Services Faculty brought together key stakeholders from the investor and analyst communities so that they might understand the respective challenges faced by banks in preparing IFRS 9 expected credit loss provisions. Here we report on the discussions around regulatory capital.

Key conclusion:

  • Regulatory capital may need to respond to the move to IFRS 9 and be more flexible going forward.

Primarily IFRS 9 seeks to address credit provisioning being ‘too little, too late’ under incurred loss (IAS 39). However, the impact of a higher provision number (incurred loss to expected loss) and its effect in reducing profit and loss (P&L) will reduce regulatory capital by c.0.4-0.5%. The stakeholders focus was less on this "Day One" impact, than on the future issues IFRS 9 presents.

The introduction of P&L volatility could also lead to volatile regulatory capital requirements. Regulators require banks to hold (upfront) the losses that might emerge in a stress. These modelled stressed losses form the basis of a bank’s ‘Pillar 2B’ capital requirements. A recent bank research note indicated the effect might be c.3%.

The importance of transitional provisions in the early years of IFRS 9 will therefore be critical to avoid a double-whammy with provisions and capital requirements increasing at the same time in a pro-cyclical manner. Transitional provisions will also help stall the legal and regulatory triggers that might have come into effect if the stress tests are failed under IFRS 9.

IFRS 9 is not a prudential standard; in that it does not seek to smooth out the cycles. It is the intent of IFRS 9 to anticipate the future and vary over time. This may mean that regulatory capital may need to respond and be more flexible going forward.

This will mean a consideration of whether there is the right amount of loss absorbing capacity/capital overall in the system and if IFRS 9 merely shifts the balance to provisioning and/or whether capital and provisions are right at the individual firm level.

Against this background, the appropriate hurdle rate for stress tests and setting the counter cyclical buffer (CCYB) for capital will need to be evaluated by regulators.