Adopting the New IFRS 9: Four Key Challenges for the Banking CFO

In conversations with CFOs of financial institutions in Asia Pacific, it is not surprising to find that top-of-mind these days is the implementation of the new accounting standard IFRS 9: Financial Instruments.

Banks and other companies still have a year to adopt this replacement to IAS 39. But as CFOs are discovering, the journey is not straightforward and uncomplicated – and there are worries about unforeseen and unintended consequences on the bank’s provisioning, capital, liquidity and leverage.

CFOs are navigating unfamiliar terrain. IFRS 9 introduces a new classification and measurement category, Fair Value through Other Comprehensive Income (FVOCI), while eliminating the categories Available for Sale, Held to Maturity  and Loans and Receivables.

It also mandates a three-stage impairment model for computing expected credit losses on loans, something that IAS 39 did not require. And IFRS 9 has new guidance on hedge accounting that requires enhanced disclosure of the organization’s risk management activity.

In a survey of 176 senior banking executives in Asia, Europe and the Middle East, 15% said they have not yet started on the IFRS 9 journey, while 27% are still conducting a gap analysis. Only 9% said their bank is in the implementation and parallel-run stage

Countdown to 2018

IFRS 9 is effective for annual periods beginning on or after 1 January 2018. Some institutions are well on the way to implementation. National Australia Bank, for example, made the decision on early adoption way back in October 2014. But others are lagging far behind.

In a survey of 176 senior banking executives in Asia, Europe and the Middle East conducted by software giant Oracle in August, 15% said they have not yet started, while 27% are still conducting a gap analysis of the requirements. Only 9% said their bank is in the implementation and parallel-run stage.

Fortunately for the laggards and those still in the early implementation stage, the experiences of early adopters and their service providers, along with research and advice by consultants and technology firms, are shedding light on the most serious issues that banks are likely to encounter.

There are numerous areas of concern, but CFOs are likely to find the following four aspects as among the most challenging – yet also the most crucial from the finance function’s point of view:

  • Creating the appropriate Expected Credit Loss (ECL) model
  • Availability and acquisition of high-quality data with the acceptable granularity
  • Integrating IFRS 9 with the existing accounting framework
  • Measuring and mitigating the impact of IFRS 9 on the bottom line

Expected Credit Losses

Regulators have identified the delayed recognition of credit losses on loans and other financial instruments as a contributory factor in the 2008 Global Financial Crisis. This is why IFRS 9 is designed to make banks recognize expected credit losses in a timely manner.

Specifically, the expected credit loss must be accounted for when the financial instruments are first recognized. This means the IBNR model – incurred but not reported – allowed under IAS 39 will no longer be operable. IFRS 9 also lowers the threshold for recognizing full lifetime expected losses.

The challenge is that IFRS 9 is principles-based and does not provide any standard model for computing expected credit losses. Banks must therefore create their own ECL model, one that would be compliant with IFRS 9 yet at the same time would not unduly affect the bank’s financial performance.

Banks have already created the building blocks of the ECL framework – probability of default (PD), loss given default (LGD) and exposure at default (EAD) – as part of their regulatory capital management under the Basel requirements. However, these must be recalibrated for the purposes of IFRS 9, which requires that debt instruments and loan commitments be categorized into three buckets.

For Stage 1 (“performing”) instruments, 12-month PD, which already exists in compliance with Basel regulations, should be used to compute expected credit loss. For Stage 2 (“underperforming”) and Stage 3 (“non-performing”) financial instruments, a new measurement called lifetime PD must be used. 

In the Sixth Global IFRS Banking Survey released by Deloitte in May last year, the availability of lifetime PD was identified as the biggest data concern, indicating how challenging it will be to produce this data point. With the CFO’s help, banks must also decide what ECL approach would be most appropriate for their unique circumstances. This could be cash flow-based, or looking at forward exposures, provision matrix, roll-rate and other factors.

CFOs will need to change parts of the accounting and reporting systems as IFRS 9 is implemented. For one, the structure of the Chart of Accounts in the General Ledger must be redefined

High-Quality Data and Data Availability

Lifetime PD is not the only data issue. IFRS 9 also requires cash flow information, collateral data, exposure information, obligor rating data and macro-economic indicators, among others. And the data is not limited to past events and current conditions. IFRS 9 also requires banks to take into account forecasts of future conditions in calculating expected credit losses.

The big global banks typically have research units that generate information about the economy and produce macro-economic forecasts. The smaller institutions will need to acquire the information from other sources, including forecasts by central banks and regulatory authorities, multilateral institutions like the World Bank, and for-profit research organizations.

Then the banks will need to calculate the impact of the forecasts on expected credit losses with regards to mortgages, other retail loans, corporate and SME exposures, and securities. Will they use a single forward-looking scenario to estimate the ECLs? If so, will it represent the weighted average of multiple scenarios? Or will it represent the scenario considered most likely?

In the Deloitte survey of 91 global and other banks, 58% of respondents said they do not know which scenario approach they will use. Half of them also do not know the maximum time horizon they will choose with regards to the macro-economic information. And 57% said they don’t know how their bank will incorporate forward-looking macro-economic information in the ECL modelling process.

The challenge for banks is to make these decisions sooner rather than later. They must also craft a clear data governance model to ensure there is a rigorous process in place in sourcing the various types of required data (which include information from the risk, finance and treasury functions), assessing their quality and granularity, timeliness and other attributes that are essential to running ECL computations and reporting.

Accounting Issues

CFOs will need to change parts of the accounting and reporting systems as IFRS 9 is implemented. For one, the structure of the Chart of Accounts in the General Ledger must be redefined to capture ECL provisions. GL entries must be recorded on the reporting date. The current account process will also need to be re-engineered to ensure that interest is accrued using the effective interest rate, not the instrument contract rate as is done currently.

The accounting categories ‘Available for Sale,’ ‘Held to Maturity’ and ‘Loans and Receivables’ will be eliminated, and a new category, ‘Fair Value through Other Comprehensive Income,’ will be created. Finance will need to hone its fair-value expertise as it relates to the instruments within the scope of IFRS 9, and study the process for determining whether a financial asset should be classified under and measured as FVTOCI, Fair Value Through Profit or Loss, or amortized value.

The CFO also faces the challenge of complying with IFRS 9’s enhanced disclosure requirements in the financial statements, particularly as it relates to the bank’s risk management activities. IFRS 9 prescribes a new hedge accounting model that more closely aligns accounting with risk management.

The objective is to satisfy the demand of investors to understand the risks that a bank faces, what management is doing to manage those risks, and how effective those risk management strategies really are.

If some in finance think their bank still have a year to complete the journey, they could be wrong. Many institutions are likely to need to run IFRS9 in parallel with IAS 39 for a year before IFRS 9 becomes mandatory

Profit & Loss Volatility

Investors and other stakeholders will also be looking at the impact of IFRS 9 on the bank’s bottom line. The challenge for the CFO is to measure the impact of IFRS 9 on net profit, find ways to do the accounting in such a way as to mitigate the negative effect while complying with the requirements of IFRS 9, and communicating all this to shareholders and other audiences.

It will not be easy. One direct financial consequence of IFRS 9 could be lower operating margins and profitability as the bank categorizes financial instruments in the three buckets. If the ECL model assigns high volumes of assets in Stage 2 and Stage 3 than was the case under IAS 39, the bank will need to set aside larger amounts in loan loss provisions.

In the Deloitte study, 81% of respondents in banks with over €100 billion in gross lending and 64% of all other respondents said they expect a significant impact on the volatility of the bank’s P&L account under IFRS 9 compared to IAS 39. According to Deloitte, “most banks estimate that loan loss provisions will increase by up to 25% across assets classes on transition to IFRS 9.”

Early implementers like the National Australia Bank prove that financial institutions can successfully complete the IFRS 9 journey and reap positive outcomes. But CFOs and others in the bank have to recognize that time is of the essence, given the complexity of the operational and accounting transformation required by the changeover from IAS 39.

And if some in finance think their bank still have a year to complete the journey, they could be wrong. Many institutions are likely to need to run IFRS9 in parallel with IAS 39 for a year before IFRS 9 becomes mandatory. This means that it is best for banks to determine their approach early in 2017, if they are to meet the January 2018 deadline.

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