Till now we understood that, IFRS-9 has introduced the concept of staging i.e. each of the loans or financial instrument will be categorized into different stages depending upon the credit deterioration of the account since initial recognition. An entity must determine whether the financial asset or liability falls into one of three stages mentioned below:
Stage 1: Loan’s credit risk has not increased significantly since initial recognition
Stage 2 – Loan’s credit risk has increased significantly since initial recognition.
Stage 3 – If the loan’s credit risk increases to the point where it is considered credit-impaired.
Depending upon the stage, a particular account falls into either 12 month PD or lifetime PD should be calculated.
- 12-month ECLs (Stage 1): Applies to all items (from initial recognition) as long as there is no significant deterioration in credit quality
- Lifetime ECLs (Stages 2 and 3): Applies when a significant increase in credit risk has occurred on an individual or collective basis
An important question that needs to be answered is, the factors which should be looked into before deciding that whether a significant credit deterioration has happened or there is a significant increase in credit risk.
What should be the Significant increase in credit risk is not been specified by IFRS-9, it is subjective and depends upon the judgement of financial institution. Let us look into criteria for a mortgage portfolio. Later on we would also look into criterion for few other financial instruments.
To begin with, Credit deterioration or Risk assessment can be divided into two categories:
- Short Term Risk Assessment
- Long Term Risk Assessment
Short Term Risk Assessment:
- Risk assessment based on 12 Months-Behavioral model (BASEL Model). 12 Month PD model as origination point of an account will be compared with 12 Month PD model at the reporting date (Current Month or Assessment Month). Two assessments are done at this point.
- Absolute Difference: 12 Month PD (Assessment Month) – 12 Month PD (Origination Month). Threshold for this criterion depends upon the business judgment e.g. Business want to capture at least 50 percent of probable defaults. Below is sample table.
|PD Score||Default Captured|
- Relative Difference: Absolute Difference (Calculated above)/12 Month PD at Origination. Threshold for this criteria is Judgmental, completely depends upon portfolio loan structure.
- Risk Assessment Based on 12 Months IFRS-9 model (Macro Economic Variable adjusted): Just like above discussed 12 Month Basel Model risk assessment, we do two step risk assessment for IFRS-9 models
- Absolute Difference: Criteria similar to BASEL Model Discussed above.
- Relative Difference: Criteria similar to BASEL Model Discussed above.
- Delinquent Population: Any account which falls into 30+ DPD should be considered high risk since t missed payment. Again depends upon business requirements in certain portfolios criteria may be 60+ DPD (Days Past Due).
- Past 12 Months Delinquent or Default Status: Any account which has been delinquent or defaulted in last 12 months (last 12 months from the reporting or assessment month) should be considered high risk account and should fall into Stage 2.
- High Probability of Default Score at origination: This criterion applies to all the accounts at origination. Threshold depends upon business judgment e.g. any account with origination Probability of default more than 20% should be tagged as high risk accounts.
There are certain other business specific criteria:
- Any account involving Foreign Exchange Risk
- Accounts acquired during certain period (Economically Stressed)
Long Term Risk Assessment:
- Annualized Residual Risk (Origination to Lifetime PD vs Reporting Month to Lifetime PD): Annualized residual risk captures the account for which lifetime residual risk is very high. In this analysis, Origination to Lifetime remaining PD (Residual Risk) is compared with Reporting Month remaining PD (Residual Risk). To understand residual risk, there is a general assumption that with time; probability of default for a mortgage portfolio should decrease. So when we refer to residual we try to remove the probability of default from the past, as till reporting month payments are already made and we trying to assess risk for future. Below graph explains the concept of residual risk.
We can see, cumulative origination PD starting from month 25th is lower than cumulative reporting month PD, which suggests that credit deterioration has happened for the account.
We calculate both absolute and relative difference to assess the credit deterioration as we did for short term risk assessment
- Year on Year Marginal PD Comparison: The Year on year marginal PD compares the incremental risk for an account. The origination marginal PD curve is compared with the reporting month marginal PD curve. If an account shows increased with for reporting month from year on year basis for any given month, then that account would be tagged as high risk.
Above given analysis are commonly used for credit deterioration but does not constitute the exhaustive list. There may few more criterions depending upon business requirements.
Let us look into few more example of credit deterioration for financial instruments.
- Credit Risk assessment for guaranteed debt instruments: Banks should assess the ability to recover cash flows from the guarantor as this also affects the assessment of whether there has been a significant increase in credit risk, particularly in instances where the collateral is likely to be used as the primary source of payment in default situations.
- Risk assessment in case of forbearance: When a borrower is in financial difficulty, to maximize recovery of the contractual cash flows of the loan a bank may offer to modify the contractual terms. Such modifications are sometimes referred to as ‘forbearance’. Since forbearance results into detrimental impact on the estimated future cash flows of that financial asset, such accounts should be tagged as high risk.
- Credit Risk for financial assets with a maturity of less than 12 months: IFRS 9 requires an entity to assess whether there has been a significant increase in credit risk for all financial assets (unless a more specific exception applies). This includes financial assets with a maturity of 12 months or less. Even though the 12 month ECL is the same as lifetime ECL for these financial assets.
In the following section we would cover Lifetime Probability of Default.
For better understanding of IFRS-9, please read from the beginning IFRS-9 Introduction