What is the bank's response to IFRS9?
IFRS9 Planning and Stress Testing
The countdown for IFRS9 launch on January 1, 2018 is fast approaching. The new standards for provisioning represent a drastic shift in bank accounting and credit risk management. Loan portfolios will not be subject to credit loss recognition based accounting any more. Instead, loans in the banking book will generally follow mark-to-market accounting principles. Bank earnings will reflect expected losses calculated based on credit quality changes and forward looking macro-economic views. Loans that have merely undergone a significant credit deterioration will be marked down. IFRS9, if implemented properly, will drive more accurate economic valuations of loan portfolios and promote earlier recognition of credit losses avoiding the delays observed during the credit crisis. As it happens with trading businesses, mark-to-market discipline will create higher P&L volatility of loan portfolios as provisions become more sensitive to the economic cycle. The increased volatility of banking books will need to be understood, measured and communicated to investors. Pricing and product design decisions will be altered. The new requirement for Stage 2 classification will drive multiple bank criteria and significant variation in implementation. Moreover, IFRS9 will bring profound changes in the way banks conduct scenario, financial and capital planning.
IFRS9 will bring profound changes in the way banks conduct scenario, financial and capital planning.
IFRS9 Impact Analysis
IFRS9 will have a significant impact. It will not only increase provision levels post adoption but more importantly will drive higher P&L volatility, particularly in periods of stress.
A&M estimates a required one-off increase in provisions of approximately seven percent for top European banks with a CET1 impact of 45bps. The main driver of impact is the lifetime provisioning feature of IFRS9 for Stage 2 exposures. IFRS9 one-off impacts are quite modest due to benign credit conditions, stable economic projections and historically low write-offs across the vast majority of jurisdictions.
However, IFRS9 will bring higher P&L volatility due to more rapid recognition of losses or provision releases. During periods of stress, migrations to Stage 2 and full incorporation of forward looking downturn scenarios will drive acceleration in impairments driving increased P&L and capital volatility. A&M analysis of pro-forma stress test impacts under IFRS9 format shows front-loading of losses in year one of planning horizon compared to more balanced impacts of prior stress tests. Top European banks are expected to have an average impact during year one of 191 bps due to credit losses in a stress test. This result would add 60bps of impact in year one compared to last EBA stress test exercise conducted in 2016. As a result, the increased sensitivity of provisions to the economic cycle creates important implications for capital planning going forward.
Investors are concerned about the pro-cyclical effects of IFRS9. Furthermore, regulators need to address treatment of additional capital drawdowns driven by IFRS9 stress tests.
IFRS9 Planning - the bank's response
IFRS9 brings multiple challenges to bank planning:
- How should we budget and plan for provisions using IFRS9 standards?
- How should governance be changed when forecasting IFRS9 provisions?
- What portfolios are more exposed to economic cycles?
- Should pricing or product design be modified? How should credit risk management practices be adapted?
- Will IFRS9 model dependencies introduce new “black box” risks?
- Will IFRS9 bring new risks for financial restatements due to model uncertainty?
To respond to the above challenges A&M has created a framework for response with 10 actionable recommendations along four key attributes: 1. Clear planning methodology, 2. Sound governance and controls, 3. Planning infrastructure and 4. Management applications.
Conclusion
In conclusion, IFRS9 will create important challenges to the banking industry. It will not only add P&L volatility but it will bring increased complexity and model risks to credit provisioning. Banks will need to adjust their governance, methodologies, infrastructure and controls to integrate IFRS9 standards in management decision making processes.
Alvarez and Marsal are a global financial services practice that has been at the forefront of working with financial institutions and governments in the wake of the credit crisis, advising on operational, financial and regulatory issues. They are sponsoring RiskMinds International, this year in Amsterdam.