The new IFRS-9 accounting standards proposed the forward looking approach for loss calculations. As per IAS-39 banks were supposed to do provisioning based on incurred losses which actually resulted into delayed recognition of losses during 2008 economic downturn.
IFRS-9 was proposed to cover the delayed losses recognition issues with IAS-39 but it also has impacts on BASEL (Capital budgeting). This article explores the impacts of IFRS-9 provisioning on BASEL-3 capital budgeting. This article will help you understand the growing interaction between Risk Management (Statistical based) and Accounting with respect to Credit Risk Modeling, Capital Ratios and Provision calculations.
IFRS-9 Provisioning: As per IFRS-9 impairment approach, for any kind of estimated cash shortfalls (1- recovery rate) over the expected life of the asset; the expected credit loss will be equal to the present value of the estimated cash shortfalls. Expected losses may be considered either on a 12-month or lifetime basis, depending on the level of credit risk associated with the asset. The projected value is then recognized in the profit and loss (P&L) statement. Since IFRS-9 tends to increase the losses thus it would result into decrease in profit and effectively reduced retained earnings in balance sheet. Retained earnings are used to calculate BASEL capital adequacy ratio.
BASEL (Capital Budgeting): Under Basel III, the minimum capital adequacy ratio that banks must maintain is 8%. The capital adequacy ratio measures a bank’s capital in relation to its risk-weighted assets. The capital-to-risk-weighted-assets ratio promotes financial stability and efficiency in economic systems throughout the world. The Capital Budgeting is done based on retained earnings which is a Balance sheet item.
So, the new IFRS 9 provisions will impact the P&L that in turn needs to be reflected in the calculation for impairment provisions for regulatory capital. Essentially, there is a need of interaction between finance and risk functions with banks.
The implementation of IFRS 9 processes that touch on both finance and risk functions creates the need to take into account the differences in culture, as well as the difference in the understandings of the concept of loss in the two functions.
The finance function is focused on product (i.e., internal reporting based on internal data) and is driven by accounting standards. The risk function, however, is focused on the counterparty (i.e., probability of default) and is driven by a different set of regulations and guidelines. This difference in focus leads the two functions to adopt these differing approaches when dealing with impairment:
- The risk function uses a stochastic approach to model losses, and a database to store data and run the calculations.
- Finance uses arithmetical operations to report the expected/incurred losses on the P&L, and uses decentralized data to populate reporting templates.
In other words, finance is driven by economics, and risk by statistical analysis. Thus, the concept of loss differs between teams or groups: A finance team views it as part of a process and analyzes loss in isolation from other variables, while the risk team sees loss as absolute and objectively observable with an aggregated view.
Basel framework follows the two for credit measurement to calculate regulatory capital:
- The standardized approach (SA) allows the bank to measure credit risk in a standardized manner, assigning risk weights supported by external credit assessments.
- The internal ratings-based approach (IRB), which is subject to the explicit approval of the bank’s supervisor, would allow banks to use internal rating systems for risk-weighted asset (RWA) calculation for credit risk.
Interaction between IFRS-9 and BASEL:
IFRS 9 requires an institution to immediately recognize either a 12-month or Lifetime ECL from a financial asset at the first reporting date after origination, and create an allowance to cover such loss.
As we can see, the expected credit loss is to be covered by provisions, and unexpected loss is to be covered by capital. As we know, the loss provisions will significantly increase under IFRS 9 thus reducing the equity and retained earnings available for Tier 1 capital, which in turn may reduce the Tier 1 capital ratio also known as capital adequacy ratio which . Banks are mandated to maintain minimum capital adequacy ratio of 8%.
As outlined in the BCBS revised framework for the International Convergence of Capital Measurement and Capital Standards, the treatment of impairment provisions differs based on the credit measurement approach used by the institution.
- The standardized approach will see a 1:1 impact on Core Tier 1 capital in case a loss has occurred, as the impact on retained earnings to cover the losses affects the availability of Tier 1 capital resources. However, in some circumstances, provisions can be included in Tier 2 capital subject to the limit of 1.25% of risk-weighted assets.
- Under the IRB approach, banks must compare the total amount of eligible provisions with the total expected loss amount as calculated within the IRB approach. There are then the following two scenarios:
i. If the expected loss is greater than the total eligible provisions, the surplus of expected loss over provision is reduced from the capital. The reduction is on the basis of 50% from Tier 1 and 50% from Tier 2. ii.If the expected loss is smaller than the total eligible provisions, the difference is recognized in Tier 2 capital up to a maximum of 0.6% (limit subject to national discretion) of credit risk-weighted assets.
Conclusion: IFRS 9 implementation offers opportunities and challenges. Banks must centralize data from numerous sources, coordinate and manage a wide variety of models, evaluate changes in credit risk, and calculate expected credit losses and provisions accordingly.