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All about IFRS 9 in 5 minutes
IFRS 9 in summary
The International Financial Reports Standards (IFRS) are a set of accounting standards being implemented by different countries across the world, which are gradually replacing the old International Accounting Standards (IAS). Their introduction heralds a major change in accounting procedures for financial institutions.
One of the standards that is going to have the biggest impact on banks is IFRS 9 (Financial Instruments) which replaces IAS 39 (Financial Instruments: Recognition and Measurement) and becomes mandatory for annual periods from 1 January 2018 onwards.
Implementation of this new single, integrated standard is being done in three phases:
- Classification & measurement of financial instruments
- Impairment of financial assets
- Hedge accounting
Main area of IFRS 9
The International Financial Reports Standards (IFRS) and the International Accounting Standards Board (IASB) detail the requirements of the IFRS 9 standard as follows:
IFRS 9 classification and measurement
Classification determines how financial assets and financial liabilities are accounted for in financial statements and, in particular, how they are measured on an ongoing basis. IFRS 9 introduces a logical approach for the classification of financial assets, which is driven by cash flow characteristics and the business model in which an asset is held. This single, principle-based approach replaces existing rule-based requirements that are considered to be overly complex and difficult to apply. The new model also results in a single impairment model being applied to all financial instruments, thereby removing a source of complexity associated with previous accounting requirements.
IFRS 9 impairment
During the financial crisis, the delayed recognition of credit losses on loans (and other financial instruments) was identified as a weakness in existing accounting standards. As part of IFRS 9, the IASB has introduced a new, expected-loss impairment model that will require more timely recognition of expected credit losses. Specifically, the new standard requires entities to account for expected credit losses from the moment when financial instruments are first identified. IFRS 9 acknowledges the full lifetime expected losses on a more timely basis.
IFRS 9 hedge accounting
IFRS 9 introduces a substantially reformed model for hedge accounting, with enhanced disclosures about risk management activity. The IFRS 9 hedge accounting model is a significant overhaul that aligns accounting treatment with risk management activities, enabling entities to better reflect these activities in their financial statements. In addition, as a result of these changes, users of the financial statements will be provided with better information about risk management and the effect of hedge accounting on the financial statements.
Source: http://www.ifrs.org
Why was IFRS 9 introduced?
One of the key factors that led to the onset of the financial crisis in 2008 was the approach that banks followed for determining losses on bad loans, under the IAS 39 guidelines. The IAS 39 incurred loss model had several shortcomings:
- Loan losses were not recognized until there was objective evidence of impairment. This delayed recognition was cited as one of the major weaknesses of the impairment model (too little too late).
- The incurred loss model exaggerated the procyclical effects of banks’ capital regulation and therefore had the potential to trigger systemic risk and impact global financial stability. Typically, credit losses tend to be at their lowest just before the start of an economic downturn, when the actual losses begin to emerge and mount.
- IAS 39 was also criticized for allowing banks to adopt different approaches for impairment computation for similar financial instruments, depending on their classification.
- The incurred loss approach was backward looking in nature and had no provision to incorporate changes in the macroeconomic environment in the computation of the economic value of the loan.
IFRS 9 introduces a forward-looking “expected loss” impairment standard that requires banks to provide more timely recognition of expected credit losses (ECL), based on future expectations, in place of the “incurred loss” model. The new standard requires banks to account for ECL on an individual financial instrument level from the moment instruments are first recognized, and not when the default happens or the loss materializes, as is currently the case.
How IFRS 9 works
IFRS 9 requires banks to make forward-looking provisions for credit losses in their balance sheet and income statements, for all financial instruments. A backward looking approach, whereby losses are only factored in after they are realized as is the case under the current IAS 39 standard, can result in too little being put aside.
This will have an immediate impact on a bank’s balance sheet on the day it switches over to the new standard. IFRS 9 will require banks to put aside a significantly higher amount. The change in provision requirements will lead to a drop in earnings reported for all banks implementing the new standard.
IFRS 9 defines two ways of assessing a loss allowance or a provision for a financial instrument:
- collective assessment of financial instruments (those assessed on a group or portfolio basis, with shared risk characteristics) and
- individual assessment of loans (instruments that are assessed on a specific basis and have been identified as impaired or non-performing).
IFRS 9 impact on banks
The changes being introduced by IFRS 9 will impact banks in the following ways:
More effective risk modeling
The new standard aims to make the calculations and the methodology used by financial institutions more risk-sensitive, rather than being top-down and rules-based. As a result, much more involved calculations are now needed at a granular level to generate the provision numbers.
To implement the changes, banks will need to review and upgrade their risk modeling capabilities so that they can adopt a more forward-looking approach that also assesses the impact of macroeconomic factors on ECL calculations.
Powerful technology systems
The underlying theme across most of the changes that the new standard imposes is that it is now vital for IFRS 9 teams to have access to clean, reconciled, granular data in a system designed to handle large volumes – not just from a storage perspective but from a processing and reporting perspective as well.
This in turn means that banks will have to make major changes and improvements to their existing data management systems and processes – and finding the right software is a key element in coping with IFRS 9.
Advance preparation needed
Although the new standard isn’t being officially introduced until January 2018, considerable preparation will be needed in the run up to it. To go live with IFRS 9 in 2018, many banks have said that they would prefer to have “parallel runs” for a period of at least 12 months prior to 2018.
As such, ideally, banks’ IFRS 9 implementations should be ready by end-2016 or early-2017, to be able to carry out parallel runs throughout 2017, and when 2018 comes, to start publishing numbers in line with the new standard.
Therefore, the changes will also initially affect the bottom lines of banks. In responding to the new challenges of impairment under IFRS 9, banks will have to develop a range of new systems and capabilities – which is likely to require a significant financial outlay.
Key challenges of IFRS 9
The new standard incorporates a forward looking expected credit loss (ECL) model for the calculation of provisions. This will have an immediate impact on a bank’s balance sheet and earnings on the day it switches over to the new standard. The key challenges for banks are as follows:
1. Financial instrument classification
Under IFRS 9, banks need to classify all instruments into one of the following three categories: amortized cost, fair value through comprehensive income (FVOCI), and fair value through profit and loss (FVPTL).
2. Stage identification
This aspect of IFRS 9 is completely new for credit provisioning. It will require banks to assign a stage to each account that has been classified for amortized cost or FVOCI. Stage assignment is based on the account’s credit risk characteristics.
3. Provision calculation
IFRS 9 provides fairly detailed guidelines on the calculation of items such as the effective interest rate (EIR), the credit-adjusted effective interest rate, the effective interest spread (EIS); and the expected credit loss (ECL), based on forward-looking assessments.
4. Credit modelling
Banks will have to use a forward-looking approach in estimating point-in-time probability default (PD) and loss-given default (LGD) for the purpose of provision calculations. In addition, banks will have to build and calibrate point-in-time models, which will require significant efforts.
5. Reporting
Once banks have started to make all these calculations on an account level granularity, they will also need to be able to report and analyse not just point-in-time data but also trends in how the provisions have evolved across all accounts.
The following assets will give you detailed information on the key challenges that banks face:
Key data requirements of IFRS 9
Banks need to institute an appropriate data governance program to originate and source quality data at a highly granular level, for IFRS 9 processing. They need to consider historical, current, and forward looking forecasts in various areas for ECL computations.
