Under IFRS 9, Financial Instruments, banks will have to estimate the present value of expected credit losses in a way that reflects not only past events but also current and prospective economic conditions. Clearly, complying with the 160-page standard will require advanced financial modeling skills. We’ll have much more to say about the modeling challenges in upcoming posts. For now, let’s consider the issues involved in classifying financial assets and liabilities.
The standard introduces a principles-based classification scheme that will require banks to look at financial instruments in a new way. Derivative assets are classified as “fair value through profit and loss” (FVTPL), but other financial assets have to be sorted according to their individual contractual cash flow characteristics and the business model under which they are held. Figure 1 summarizes the classification process for debt instruments. There are similar decisions to be made for equities.
The initial classification of financial liabilities is, if anything, more important because they cannot be reclassified. Figure 2 summarizes the simplest case.
That’s only the first step. Once all the bank’s financial assets have been classified they have to be sorted into stages reflecting their exposure to credit loss:
- Stage 1 assets are performing
- Stage 2 assets are underperforming (that is, there has been a significant increase in their credit risk since the time they were originally recognized)
- Stage 3 assets are non-performing and therefore impaired
These crucial determinations have direct consequences for the period over which expected credit losses are estimated and the way in which effective interest is calculated. Mistakes in staging can have a very substantial impact on the bank’s credit loss provisions.
In addition to the professional judgment that any principles-based regulation or accounting standard demands, preparing data for the measurement of expected credit losses requires creating and maintaining both business rules and data transformation rules that may be unique for each portfolio or product. A moderately complex organization might have to manage hundreds of rules and data pertaining to thousands of financial instruments. Banks will need systems that make it easy to update the rules (and debug the updates); track data lineage; and extract both the rules and the data for regulators and auditors.
IFRS 9 is effective for annual periods beginning on or after January 2018. That’s only about 18 months from now. It’s time to get ready.