Caroline Biebuyck 5 Dec 2017 01:38pm

Playing the financial instruments

IFRS 9 will revolutionise how loans are treated in banks’ accounts, but what might it do to their customers’ ability to borrow? Caroline Biebuyck investigates
Caption: Illustrations: James Olstein
IFRS 9 is finally here. After years of discussion, planning, then implementation, the new accounting standard on financial instruments comes into force for accounting periods starting from 1 January 2018.

The expectation is that under the new standard banks will report their loan losses sooner than they would have previously. This was certainly the intention of the standard setters, who were keen to stop the pro-cyclical impact of significant losses being recorded during a downturn as infamously happened during the financial crisis of a decade ago.

A key question at this stage is how much IFRS 9 will change banks’ reported provisions. The answer seems to be falling over time. Initial projections suggested an estimated increase in provisions of 50%. Then a survey by the European Banking Authority (EBA) published in November 2016 gave an estimate of 18%. By July 2017, this had fallen to 13%.

This drop in expected increase is mainly due to low interest rates and calm economic conditions. The current position in the economic cycle means there is a low probability of default, says Andrew Spooner, audit partner at Deloitte. “The point of the standard is that you should take into account the potential that debts will go bad in the future, based on forward-looking economic projections.”

Impact on business

What impact will the new standard have for businesses trying to borrow? SMEs in particular already have problems getting the finance they need from traditional lenders: a report published by Close Brothers in November 2016 concluded that SMEs’ individual financing needs are not being met, with almost half of those surveyed experiencing
barriers to accessing finance. As Brexit requires British businesses to step up their game, might the impact of IFRS 9 make it even harder for them to access the finance they need to grow?

Some products and business lines will be less profitable because of IFRS 9, thinks Zsuzsanna Schiff, audit and reporting manager at ICAEW’s Financial Services Faculty. “Most banks are going to have to review their strategy and concentrate on lines that are less sensitive to the move from stage 1 to stage 2.”

The main thrust of IFRS 9 is to ditch the incurred loss model of the past, in which banks could only recognise a provision against a loan once the loss had been incurred, for an expected loss model, which looks at the credit risk attached to the loan.

Under the new model, loans fall into three stages, with the staging depending on the change in credit risk. Stage 1 loans are those for which there has been no significant increase in credit risk: here the bank makes a 12-month expected loss provision.

The loan moves up to stage 2 if there is a significant increase in credit risk. At this point, the provision against the loan increases to the expected loss over the whole life of the loan. Once the loan is actually impaired it moves into stage 3, when a full provision is needed. Mike Morgan, chief finance officer of Close Brothers’ banking division, says: “IFRS 9 is about the timing of acknowledging impairment. The impairments will be the same – they won’t be any more or less as a result of this. We continue to maintain our strict lending and underwriting criteria, and this allows us to continue to lend through the cycle. Once the initial provision has been put aside, we will see increased volatility. But this won’t change the way we view our customers and the rigorous controls on how we write our business.”

However, David McCarthy, CFO of challenger Atom Bank, sees a potential for the standard possibly holding the lending market back slightly. Capital is always tight at an early-stage start-up bank, he says. “If you take the standardised rather than the internal ratings-based capital approach, which most challengers do, then your provisions deplete capital. That may mean you favour less capital-consumptive types of lending, such as residential lending, which is low risk.”

Managing risk

The problem is that no one likes the idea that on day one the bank has to book at least a 12-month loss on the money it has just lent, says Brendan van der Hoek, IFRS specialist at Santander. “But the business approach is that the accounting standard should not affect what we do as a bank, as we should continue to lend according to our credit risk appetite and in accordance with our risk management practices.”

The question that will emerge over time, says Richard Lawrence, head of accounting policy at RBS, is whether banks need to rethink how they approach secured and unsecured lending (the latter is treated less favourably under IFRS 9) and their view on long-dated assets and committed facilities. “None of this will change on day one but these are things that the banks will monitor in the near term to work out the extent of the change brought by the standard, and whether that change is enough to alter the way they consider these.”

One of the greatest practical ongoing problems of IFRS 9 is in deciding when there is a significant increase in credit risk attached to a loan. Regulators across Europe are concerned about this because of the volatility that IFRS 9 will bring to regulatory capital, says van der Hoek. “They want to understand the different touchpoints, such as whether banks will have similar triggers for moving from stage 1 to stage 2, so that if credit deteriorates the banks will move in a similar direction.”

One of the tough questions that Lawrence and his team had to field from RBS’s executives was: how do you know when you’ve got the stage 2 balance correct? “You don’t. There’s no back test for deteriorated assets. You can prove that a loan should have been in stage 1 or stage 3 by looking at what happens at maturity. But nothing ends up as deteriorated: you can’t prove that it should have been in stage 2.”

All banks have confronted major data issues on introducing the standard. RBS, for example, has had to create about 120 new data fields and run them across 21 million line items to run the IFRS calculations on every asset it holds. But while established banks had a cache of prior data with which to work, challenger banks started with a blank slate.

Data was, and still is, an issue for Atom Bank, says McCarthy. “IFRS 9 is a very data-hungry standard, as you need data to assess your expectations of credit losses for different categories by loan-to-value band and type of loan. Since we had little data we had to make assumptions, which we based on publicly available data we bought to analyse. The analysis does not fully hold together until you’ve been through at least one cycle, and preferably a few, before you can start to pick out the patterns.”

The other major challenge is economic modelling: IFRS 9 requires banks to predict the range of future events that might have an impact on their losses. All banks have to produce their own economic projections, says Spooner. “They then have to tie this into the loan book and probability weigh different scenarios to come up with their expected credit loss adjustments.”

Keeping it consistent

At the moment banks are operating in a relatively benign environment, says Morgan. “If dark clouds start to come across the economic horizon then the numbers would increase. Applying that macro-economic view consistently across the industry is important. Any inconsistency would give quite different results, which would be something for the regulator to chew over.”

Lawrence thinks that many banks are so caught up with the transition and day one impact that they have not had time to consider what happens next. “Because credit and economic conditions have been relatively stable for the last couple of years, the day one impact is showing credit risk levels lower than the normal long-term average. If the economy deteriorates, how quickly does that flow through your profit and loss and how volatile do the numbers become?”

Another test will be disclosures: how they will work, will they be comparable across the industry, and will they include too much information and be confusing. Schiff says that analysts appear to be expecting IFRS 9 to bed down within two years, by which time they think they will be able to understand and make a sensible comparison of disclosures. “I think that is quite optimistic, although it’s difficult to tell until things start. There is an eerie silence now – we will have to wait and see what happens.”