the use of ifrs for prudential and regulatory...

The Use of IFRS for Prudential and Regulatory Purposes Revision of IAS 39

REPARIS IFRS Seminar Vienna, May 3-4 2010

Summary

»  Introduction

»  Provisioning according to IAS 39 (Loans & Receivables)

»  Loan loss provisioning according to ED/2009/12 (Amortised

Cost and Impairment)

»  Basel Committee Proposal for expected Loss (EL)

Provisioning

»  European Banking Federation Proposal “Expected Loss over

the Life of the Portfolio (ELLP)”

»  Comparison of the various approaches 1

Introduction

»  The financial crisis has shown limitations of the current incurred loss accounting model used in IAS 39:

•  Overstatement of interest income in the periods preceding the occurrence of a loss event

•  Insufficient amount of accumulated provisions to absorb actual losses that emerged during the crisis

•  Inherent pro-cyclical impact on the income statement

2

Introduction (continued)

»  Pressure on IASB: •  Acceleration of IAS 39 replacement project (IFRS 9: Financial

Instruments), conducted in three phases:

-  Phase 1-Classification and Measurement (completed in Nov. 2009)

-  Phase 2-Impairment Methodology : ED 2009/12 Amortised Cost and Impairment, based on expected cash flow model, published in Nov. 2009, comments due June 2010, final standard expected end 2010

-  Phase 3-Hedge Accounting (ED expected in first half of 2010)

3

Introduction (continued) »  Reactions to ED 2009/12 show support for the more forward

looking approach of the proposed expected cash flow model, resulting from the removal of the trigger event constraint

»  However, concerns regarding complexity, subjectivity, volatility and (remaining) pro-cyclicality

»  Particular interest of banking supervisors in phase 2 and ED, as lending is an essential feature of the banking industry. Building on supervisory objectives* , the Basel Committee on Banking Supervision has developed a modified proposal for Expected Loss Provisioning (unpublished as of now) and has entered into talks with IASB

»  Also proposal by European Banking Federation (“Expected Loss over the life of the portfolio”).

*as pronounced in guidance of Central Bank Governors and Heads of Supervision of January 2010 and Basel Committee’s August 2009 Guiding Principles for the replacement of IAS 39

4

Provisioning according to IAS 39 (Loans & Receivables) »  Basis: IAS 39.58ff “Impairment and uncollectibility”, IAS 39.63 for

loans and receivables (and HTM investments carried at amortised cost)

»  Incurred loss model; requires objective evidence (trigger event) »  Amount of loss measured as difference between asset’s carrying

amount and present value of estimated future cash flows (excluding future losses not incurred), discounted at original effective interest rate

»  Collective loan assessment possible for insignificant loans. »  Assessment on portfolio basis for non-impaired loans (“GLLP”),

considering the loss identification period (account for “losses incurred but not reported”)

»  Country risk considered within collective assessment or separately on portfolio basis

»  Reversals of write-downs up to amortised cost 5

Provisioning according to ED 2009/12 (Amortised Cost and Impairment) »  Expected loss/expected cash flow approach for assets

carried at amortised cost; on collective basis or individual basis. »  Allowance for expected future losses is gradually built over the

lifetime of an asset by deducting a margin for future credit losses from gross interest revenue (=> effective interest rate - EIR): •  Upon initial recognition of a financial asset, management estimates

credit losses expected over the life of the asset •  Interest revenue is adjusted by a margin for initially expected future

credit losses •  Over time, allowance is built for expected future credit losses by

reducing the amount of net interest revenue recognized to reflect an estimate of expected losses

•  Management estimates expected future credit losses on an ongoing basis

•  Any changes in credit loss expectations – both favorable and unfavorable – are recognized immediately on a discounted cash flow basis as a gain or loss in earnings. 6

Basel Committee Proposal for Expected Loss (EL) Provisioning »  Expected loss model, using IASB’S model for fixed rate loans as

starting point. Extended to variable rate loans by varying the contractual interest rate.

»  Recognises interest income on basis of EIR; EIR determined by applying single loss rate evenly to principal and interest over the life of the loan.

»  Loss rate includes quantitative element based on historical losses covering at least a complete economic cycle.

»  Interest payments received are allocated to interest income according to the EIR, excess set aside in allowance account.

»  Revisions of EL only when there are material changes to loss rates (objective and auditable evidence); subsequent revision of EIR will result in adjustment to the allowance account and the income statement over the residual life of the loans.

»  Open portfolio approach »  General principle: expected loss covered by provisions,

unexpected loss covered by regulatory capital

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»  “Expected Loss over the Life of the Portfolio (ELLP)” •  Expected loss approach with elements of incurred loss model;

application on loan-by-loan basis, closed or open portfolios. •  ELLP spread in the income statement over the average life of the portfolio

(linearly or any better allocation). •  Changes in expectations about ELLP spread over remaining life of portfolio. •  Loans on which incurred losses are identified (“non-performing loans”), are

separated from the portfolio. No further expected loss is calculated and the EL previously created allocated to the non-performing loans.

•  An incurred loss impairment allowance is calculated for the non-performing loans and adjusted against the expected loss impairment allowance account. “Reflects the fact that non-performing loans are the crystallization of the expected loss.” Indicates intention to use impairment allowance created for whole portfolio (not pro rata)

•  To the extent that impairment allowances are not sufficient to absorb losses, incurred losses are booked directly to the income statement

» 

European Banking Federation Proposal

8

Comparison of the various approaches

1. Pro-cyclicality

IAS 39

High; danger of excess dividend payouts in peak times, additional burden in downturns.

ED 2009/12

Lower than under IAS 39, but volatility of income statement in case of changes of credit loss expectations .

BCBS

Lower than under IAS 39 and ED 2009/12 as revisions of EL lead to adjustments over the residual life of the loans.

EBF

Lower than under IAS 39 and ED 2009/ 12; potentially higher than BCBS if EL calculation is stopped for whole portfolio in case of non-performing loans.

8 88


2. P&L Matching

IAS 39

Asymmetry of risk premiums and expenses leads to increased volatility of P+L.

ED 2009/12

Symmetry of risk premiums and expenses.

BCBS

Symmetry of risk premiums and expenses.

EBF

Symmetry of risk premiums and expenses, at least while loans in portfolio are performing.


3.Timing of provisioning

IAS 39

Later (problem of timely identification of loss/trigger event, loss identification period).

ED 2009/12

Earlier, from day 1 (granting/ extention of loan).

BCBS


EBF


Comparison of the various approaches 4.Relevance of portfolios

IAS 39

Primarily loan-

by-loan basis;

portfolio

allowance

possible for

insignificant

loans or losses

„incurred but not

reported“; lower

overall relevance

of homogeneity

of portfolios.

ED 2009/12

Approach implies

loan-by-loan or

closed portfolio

basis;

homogeneity of

portfolios

(similar risk

characteristics)

highly relevant.

BCBS

Allows open

portfolios;

homogeneity of

portfolios

(similar risk

characteristics)

highly relevant.

EBF

Allows open

portfolios;

homogeneity of

portfolios

(similar risk

characteristics)

highly relevant.


5. Complexity

IAS 39

Low, definition of trigger events only, no comprehensive loss statistics and modeling required.

ED 2009/12

High, difficult to model all risk factors of a portfolio; regular backtesting necessary to review credit loss expectations.

BCBS

High, but workload should be lower as revisions of EL only in case of material changes of loss rates.

EBF

High, as expected loss for each portfolio should be reviewed and recalculated periodically, at each reporting period.


6. Objectivity, level of judgement

IAS 39

In case of early recognition of loss event, estimation of expected cash flows may be difficult.

ED 2009/12

Increased level of judgement because periodic estimates of expected cash flows required; quality of model outputs highly dependent on parameters.

BCBS

judgement required with regard to EL estimates; quality of model outputs highly dependent on parameters.

EBF

judgement required with regard to EL estimates; quality of model outputs highly dependent on parameters.

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