Everything about IFRS 9 – Is it Compliance, Excellence or Innovation?

Preamble

There is a lot written about IFRS 9 already. During our internal research and sales question-answer sessions, many of the colleagues reported how the information has been dispersed across sources for someone to get an actionable bird’s eye view around IFRS 9. The objective of this blog on IFRS 9 is to bring out the what, why and how parts of IFRS 9, and its associated automation, in one place for the benefit of practitioners and related stakeholders. 

IFRS 9

IFRS9 has replaced IAS 39 and specified how an entity should classify and measure financial assets, financial liabilities, and some contracts to buy or sell non-financial items. It incorporated a forward-looking expected credit loss (ECL) model for the calculation of provisions which was poised to fundamentally alter the amount of profit that a bank would report in the forthcoming times.

Right after the implementation of IFRS9,  financial institutions had to adapt to changes in systems, processes and adopt automation to factor in the provisions of IFRS 9 in a cost-effective and scalable way.

Implementation of the new single, integrated standard was done in three phases:

  • Hedge Accounting
  • Classification and measurement of financial assets
  • Impairment

These are the five key areas of the changes introduced by IFRS9

1.Classification of Financial Instruments

  • Under IFRS 9, banks needed to classify all instruments into one of the three categories:
  • Amortized cost
  • Fair value through comprehensive income (FVOCI)
  • Fair value through profit and loss (FVPTL)

These classifications were based on contractual cash flow characteristics of the instrument and the business model for managing the product.

2.Identification of stage

A completely novel aspect of IFRS 9’s credit provisioning required banks to assign a stage to each account that has been classified for amortized cost or FVOCI. Stage assignments were based on credit risk characteristics:

Stage 1 – the account shows signs of doing well, with no deterioration

Stage 2 – signs of credit quality worsening

Stage 3 – there is clear evidence that the customer is having trouble with repayment:  Impairment 

3.Calculation of Provision

IFRS 9 laid down very detailed guidelines on the calculation of items such as the effective interest rate (EIR), the credit-adjusted effective interest rate, the effective interest spread (EIS); and the expected credit loss (ECL), these were based on forward-looking assessments.

4.Credit modelling

IFRS9 laid down clear guidelines for Banks to use the forward-looking approach in estimating point-in-time probability default (PD) and loss-given default (LGD) for provision calculations. Banks were also required to build and calibrate point-in-time models. They could also use an alternative method wherein they would adopt a hybrid approach. Through the hybrid approach, banks could modify the “through-the-cycle” (TTC) PD models which were being used for regulatory capital calculations.

5.Reporting

Reporting formed an essential part of the guidelines laid down by IFRS9. This required banks to report and analyze point-in-time data and trends in how the provisions evolved across all accounts. But this could be done only after banks made the calculations on an account level granularity.

Implications of IFRS 9 on Financial Institutions

IFRS 9 has affected the business models, processes, analytics, data, and systems across several dimensions.

1.Capital, Lending, Underwriting and Origination

  • It increased provision levels substantially and affected capital levels and deal pricing as compared to IAS.
  • Banks were required to estimate and book an upfront, forward-looking expected loss over the life of the financial facility and monitor for any ongoing credit-quality deterioration.

2.Asset Reclassification, Reconciliation and Measurement

  • Banks were needed to reclassify assets and reconcile them with IAS. The guidelines also required banks to map products that could be categorized before the calculation (contractual cash flow test) or create a workflow to capture the purpose (business model test).
  • Institutions needed to align, compare, and reconcile metrics consistently (e.g., Basel vs. IFRS 9).

3.Banks and Financial Institutions were mandated to coordinate finance, credit, and risk resources for which the then accounting systems were not equipped.

4.IFRS 9 provisions required banks to evaluate at origination, how economic changes would affect their existing business models, capital plans, and provisioning levels

5.In other changes, Data systems, Processes, Reporting and Automation also required an overhaul.

6.There was a need to make the provisioning exercise a cross-functional activity, with coordination needed across the risk, finance, accounting, and business functions.

After IFRS9 was implemented, there was a pressing need for banks to make way for the following changes: –

  • More effective risk modelling
  • Powerful technology systems
  • Urgent compliance with upcoming deadlines
  • Building an Expected Loss Model with Credit parameter modelling, Cash flow calculation, Provision method

How can technology help banks to optimize IFRS 9: A one-stop-shop solution

1.Addressing the Impairment challenge first

A great solution should be able to provide a framework for the calculations needed to ensure compliance with the standard. It should be equipped with an advanced engine that computes cash flows at an instrument level, which could then be used by the impairment module for provision calculations.

There should be prebuilt rules and workflows for stage assessment based on commonly based assessment criteria such as rating migration, days-past-due migration, industry classification and PD migration. The solution should allow users to configure additional rules based on their own models for stage assessment.

2.A great solution should also allow banks to actively incorporate risks into their decision making, and deliver actionable customer, business line and profitability insights. It should also help banks to promote a transparent risk management culture, and promote pervasive intelligence across departments.

3.The solution should also aim to maximize existing investments in risk and finance systems.

4.Allow for re-utilization of existing data, business rules and technology infrastructure, reducing costs and time-to-market.

5.Consolidation of data and technology for risk and finance.

6.Comprehensive data management and computations, accounting and reporting.

In Summary- The Road Ahead with IFRS 9

Forward-thinking banks took IFRS 9 compliance as an opportunity to improve their existing systems. They used it to maximize investments, reduce costs, strengthen investor relations, enhance transparency, and improve time-to-market.

It helped them to be future-forward and lay down foundations for better banking and financial compliance. IFRS9 set the stage for a significant overhaul in the banking and finance domain with the ultimate aim of helping financial institutions to be more well informed and make strategic decisions towards risk and its mitigation.

Resources: https://www.oracle.com/webfolder/s/delivery_production/docs/fy16h1/doc28/IFRS9ImpairmentPrinciples.pdf?elq_mid=53867&sh=26142251822152224161815181241113&cmid=BUMK160829P00001