With only months to go to the live date of March 2018, IFRS 9 raises many issues. Banks are at various levels of preparation and face different challenges according to their size and experience. And the new regulation has significant knock-on effects beyond compliance.
Typically, banks will start with tactical measures to meet the deadline (Day 1), moving on to automation and embedding of processes (Day 2), with an end goal of capital optimization (Day 3). This will require a realignment of functions across the organization, including finance, risk and lines of business, and will bring greater awareness of credit risk into decision making.
Many smaller banks have left preparation late, even for the impairment rules. They often underestimated how many tentacles IFRS 9 has and how far they reach
The three-phased approach
The response to IFRS 9 will typically follow three phases. Day 1 is compliance – simply meeting the requirements by the deadline. Few banks will have comprehensive, fully developed systems in place by March 2018, so methods will be at least partly spreadsheet- and manual-based.
Day 2 is the automation of processes, replacing shortcuts and workarounds and embedding IFRS 9 in business-as-usual. This includes automating workflow around the classification of new deals, the response to credit events, and the staging of impairment. (Automation will be essential if the eventual goal of pre-deal estimation of risk and return and impact on capital is to be achieved.)
Day 3 – because of the impact of expected losses on capital requirements under the new regime, banks will be looking to optimize capital, which will require realignment and greater cooperation across the enterprise, including finance, risk and lines of business.
Preparation for compliance
The larger Tier 1 and 2 banks are generally better prepared for Day 1, especially in terms of the new rules on how impairment is handled. An issue that remains outstanding for some is embedding the required stress testing in credit risk modelling in a way that satisfies governance requirements.
Tier 1 and 2 banks have an advantage in that they mostly opted for the internal ratings-based (IRB) approach under Basel II and so are experienced in credit modelling.
They have had to reformulate their models from Basel II's through-the-cycle measurement of probability of default (PD), exposure at default (EAD) and loss-given-default (LGD) to point-in-time projections under IFRS 9. But this is easier than having to start credit modelling from scratch as banks taking the standardized approach under Basel II are have to do.
Many smaller banks have left preparation late, even for the impairment rules. They often underestimated how many tentacles IFRS 9 has and how far they reach. They now face significant Day 1 challenges in terms of managing data, putting processes and controls in place and creating the infrastructure to support compliance.
They will need to take a tactical approach initially, using spreadsheets and manual methods to meet the deadline, and then working towards more strategic solutions. On the plus side, because of their size, smaller banks can often get all the relevant people together in one room to address the issues.
Given the challenges, preparation timetables have slipped in many cases. With the focus on the hard elements such as data and calculations, many of the softer issues have not received full attention, such as systems of governance, the management information that the committees and meetings might need, and how to work with the business on new products and pricing.
Classification and measurement
Although larger banks are generally well prepared for the new impairment rules, they have paid less attention to the requirements for classification and measurement (C&M) of financial instruments and liabilities.
This is partly because elements such as the effective interest rate (EIR) are the same as under IAS 39. However, banks have not necessarily understood some of the deeper implications of the rule change.
Forward-looking, big-picture thinking, including consideration of potential existential developments such as Brexit or Trump, have not been core competencies in finance
For example, they will no longer be able to use straight line approximations to accrue interest, and fee amortizations will have to be based on EIR, which will be complex for lending books with multiple fee levels.
A poll of 80 participants in a recent IFRS 9 webinar conducted by Misys revealed that:
- only 5% of the banks represented will have achieved full automation and the desired end state of their IFRS 9 implementation by the March 2018 deadline
- 16% will have achieved more than 75% of automation
- 21% will have achieved more than 50% of automation
- 4% will have achieved more than 25% of automation
- 20% will have achieved less than 25% automation, with spreadsheets and workarounds used to compute the right numbers
- 34% don't know
The data issue
No compliance project can operate in isolation anymore. While banks have been addressing IFRS 9, they have also been dealing with the Basel Committee on Banking Standards’ principles for risk aggregation and reporting (BCBS 239), the fundamental review of the trading book (FRTB), and a number of other new regulations.
In almost all cases, there is an underlying issue of data, for which a central, comprehensive, high quality data store would seem to be the ideal answer. However, the complexity, cost and timescale of creating such a resource means banks must have pragmatic alternative solutions, at least for the interim.
It will make sense in terms of efficiency and consistency to align activities across regulations where possible – for example, aligning IFRS 9 stress testing for expected credit losses (ECL) with general Internal Capital Adequacy Assessment (ICAAP) stress testing.
New skills in finance
The change in reporting with the advent of IFRS 9 and the attention that is likely to be paid by the market to the new numbers has significant implications for skills requirements. Finance people will need to know not just what the acronyms PD, EAD and LGD stand for, but must be able to explain them, and how they affect the accounts.
Forward-looking, big-picture thinking, including consideration of potential existential developments such as Brexit or Trump, have not been core competencies in finance. Anticipating what could affect interest rates or key exchange rates and impact on lending and provisions will be necessary. This could require retraining, or bringing risk or other experts into finance.
The branding problem
IFRS 9 has a branding problem. Unlike FRTB, which speaks directly to the need for deep and wide-ranging change in the trading book, IFRS 9 sounds like it is an accounting-only problem.
The challenge is to get departments across the organization to engage with the new regulatory regime and understand the impact it will have on things like terms and conditions, pricing, and the choice of clients and sectors.
It will take education and training and initiating discussions between finance, risk and lines of business to get the understanding disseminated through the organization. This is not about compliance, but about reaching a state of maturity where IFRS 9 is embedded in the business.
A catalyst for change
Day 3 is about realigning the organization for better informed decision making and improved performance in the lending business.
IFRS 9 sets provisioning requirements for lending taking full account of credit risk over the lifetime of loans and is likely to result in an increase in provisions. Because of the cost of capital tied up in such provisioning, banks must seek to make the best lending decisions based on the real risk, or cost of capital, and the return.
Banks need to redefine the meaning of performance, taking into account all the various costs, risks and true returns
Capital is allocated to each line of business for its activities and the board expects the highest return on the capital, adjusted for the risk taken to achieve it (risk-adjusted return on capital, or RAROC). Unless a line of business achieves a commercial margin from its activities above RAROC, it is destroying value.
Under IFRS 9, provisioning starts at origination. Therefore, the line of business must be able to undertake RAROC analysis pre-deal and on-demand. This requires a major convergence of functions across the bank – finance, risk and lines of business – and their technology and models (credit decision, level of capital and level of provisioning).
Banks need to redefine the meaning of performance, taking into account all the various costs, risks and true returns. They will need to reassess clients and their profitability, and adapt their products and pricing strategies.
The ultimate goal is to enable corporate lending relationship managers to do pre-deal what-if analysis on pricing spreads to optimize RAROC, taking into account future potential customer business and revenue streams.
About the Author
Arnaud Picut is Global Head of Risk Practice at financial software solutions company Misys.