Following the global financial crisis, there was a significant amount of criticism leveled at current accounting, with a number of international bodies - including the G20 and the Financial Stability Board - calling on global accounting standard setters to re-evaluate the standard for determining loan loss allowances.
Their solution was International Financial Reporting Standards (IFRS) 9, which is set to come into force on January 1, 2018. The International Accounting Standards Board (IASB) developed IFRS 9 as part of a suite of measures, focusing on three primary areas: classification and measurement of financial instruments, hedge accounting, and impairment.
The change to how impairment is calculated is the most significant area of impact. Under the new standard, banks will have to determine loan loss allowances on an ‘expected’ loss basis, moving away from the existing ‘incurred loss’ approach. This essentially means that they will have to recognize not only credit losses that have already occurred, they will also have to include losses that they expect to incur in the future throughout the entire life of the loan. Andrew Spooner, lead IFRS financial instruments partner at Deloitte has argued that ‘it is an improvement in three levels,’ as ‘the hedge-accounting requirements are more aligned with risk management activities and there is a more consistent approach to criteria for classifying a financial asset.’
Deloitte has also argued that the change in methodology will be the most far-reaching in history for many banks, likely requiring them to increase loan loss provisions by as much as 50%, which is in turn likely to result in lower reported earnings. With such dramatic ramifications, you would imagine that banks would be in somewhat of a hurry to prepare themselves. However, even though IASB member Sue Lloyd said earlier this year that we are now at ‘half time in the race towards IFRS 9 compliance,’ in a recent Deloitte survey of 91 banks across the globe, 99% of respondents said their local financial regulator hasn’t set out how they will incorporate IFRS 9 numbers into regulatory capital requirements, and 46% of big banks around the world are unprepared for its introduction and lacking sufficient resources to deliver changes by the 2018 implementation date. A Wolters Kluwer survey of Asian banks found similar results, with 66% of respondents saying they have not even started the IFRS 9 implementation process.
The reluctance to prepare may well simply be the result of a resistance to the core principles of the new standard. Tim Bush, head of governance at shareholder pressure group Pirc and an outspoken critic of IAS 39, has argued that, ‘The standard may well be practically unworkable as the key measure of 12-month expected losses has no rational economic basis and is unlikely to inform any lending decisions, which should be appraised on lifetime losses.’ Many seem to agree with his sentiments, but whether true or not, as the deadline approaches, the IFRS is unlikely to change their mind. And there is much to prepare.
Chris Spall, KPMG’s global IFRS financial instruments leader, notes ‘Estimating impairment is an art, rather than a science. It involves difficult judgements about whether loans will be paid as due – and, if not, how much will be recovered and when. The new model widens the scope of these judgements. Preparers will have to make new judgements, auditors will have to review them, and users of financial statements, including prudential and securities regulators, will have to understand them. A major issue for banks and investors in banks will be how adoption of the new standard will affect regulatory capital ratios. Banks will need to factor this into their capital planning and we expect users will be looking for information on the expected capital impacts. Credit risk is at the heart of a bank’s business and applying the new standard will depend heavily on a bank’s credit systems and processes.’ There is much to do, and banks will need to do it quickly.